DP10849 Precautionary Savings, Illiquid Assets, and the Aggregate Consequences of Shocks to Household Income Risk

Author(s): Christian Bayer, Ralph Lütticke, Lien Pham-Dao, Volker Tjaden
Publication Date: September 2015
Keyword(s): incomplete markets, nominal rigidities, uncertain shocks
JEL(s): E12, E22, E32
Programme Areas: Monetary Economics and Fluctuations
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=10849

Households face large income uncertainty that varies substantially over the business cycle. We examine the macroeconomic consequences of these variations in a model with incomplete markets, liquid and illiquid assets, and a nominal rigidity. Heightened uncertainty depresses aggregate demand as households respond by hoarding liquid ``paper'' assets for precautionary motives, thereby reducing both illiquid physical investment and consumption demand. This translates into output losses, which a central bank can prevent by providing liquidity. We show that the welfare consequences of uncertainty shocks crucially depend on a household's asset position. Households with little human capital but high illiquid wealth lose the most from an uncertainty shock and gain the most from stabilization policy.