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Federal Reserve Bank of Minneapolis
Staff Report
Wealth and Volatility
Jonathan Heathcote
Fabrizio Perri
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.


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Jonathan Heathcote & Fabrizio Perri, Wealth and Volatility, Federal Reserve Bank of Minneapolis, Staff Report 508, 23 Feb 2015.
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Keywords: Business cycles; Aggregate demand; Precautionary saving; Multiple equilibria
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