Report

Wealth and Volatility


Abstract: Periods of low household wealth in United States macroeconomic history have also been periods of high business cycle volatility. This paper develops a simple model that can exhibit self-fulfilling fluctuations in the expected path for unemployment. The novel feature is that the scope for sunspot-driven volatility depends on the level of household wealth. When wealth is high, consumer demand is largely insensitive to unemployment expectations and the economy is robust to confidence crises. When wealth is low, a stronger precautionary motive makes demand more sensitive to unemployment expectations, and the economy becomes vulnerable to confidence-driven fluctuations. In this case, there is a potential role for public policies to stabilize demand. Microeconomic evidence is consistent with the key model mechanism: during the Great Recession, consumers with relatively low wealth, ceteris paribus, cut expenditures more sharply.

Keywords: Aggregate demand; Business cycles; Multiple equilibria; Precautionary saving;

JEL Classification: E21; E12;

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Provider: Federal Reserve Bank of Minneapolis

Part of Series: Staff Report

Publication Date: 2015-02-23

Number: 508

Pages: 49 pages