Working Paper

Does Unemployment Risk Affect Business Cycle Dynamics?

Abstract: In this paper, I show that the decline in household consumption during unemployment spells depends on both liquid and illiquid asset positions. I also provide evidence that unemployment spells predict the withdrawal of illiquid assets, particularly when households have few liquid assets. Motivated by these findings, I embed endogenous unemployment risk in a two-asset heterogeneous-agent New Keynesian model. The model is consistent with the above evidence and provides a new propagation mechanism for aggregate shocks due to a flight-to-liquidity that occurs when unemployment risk rises. This mechanism implies that unemployment insurance plays an important role as an automatic stabilizer, particularly when monetary policy is constrained.

Keywords: heterogeneous agent model; liquid and illiquid assets; Unemployment insurance; Unemployment risk;

JEL Classification: E10; E24; E32; E62; J64;

https://doi.org/10.17016/IFDP.2020.1298

Bibliographic Information

Provider: Board of Governors of the Federal Reserve System (U.S.)

Part of Series: International Finance Discussion Papers

Publication Date: 2020-09-18

Number: 1298