Wealth and Volatility∗
Jonathan Heathcote

Fabrizio Perri

Minneapolis Fed and CEPR

University of Minnesota, Minneapolis Fed, NBER and CEPR

preliminary and incomplete
May 2012

Abstract
We document that in the US over the course of the past century there has been a systematic
negative relation between household wealth and business cycle volatility. We develop a microfounded dynamic equilibrium model that contains elements of a traditional Keynesian frameworkin which economic fluctuations can be driven by sunspot-type fluctuations in household optimism
or pessimism. The novel feature is that the scope for equilibrium fluctuations due to “sunspots ”
depends on the (exogenously given) value of household wealth. When wealth is high consumers
demand is not sensitive to unemployment expectations and the economy is robust to confidence
crisis. When wealth is low, consumers’ demand is sensitive to unemployment expectations, theeconomy becomes vulnerable to confidence-driven fluctuations and is, in general, more volatile.
In this case, there is a potential role for public policies to stabilize demand. We conclude byproviding micro-economic evidence on the importance of wealth in affecting the sensitivity ofdemand to aggregate conditions. We show that during great recession consumers with low
wealth, ceteris paribus, are those who cut expenditures more sharply.
Keywords: Business cycles, Aggregate Demand, Multiple Equilibria
JEL classification codes: E12, E21∗

We thank seminar participants at several institutions and conferences for very valuable comments. We also thankMark Aguiar for an excellent discussion.

1

Introduction

Figure 1 documents the relationship between household wealth and aggregate volatility in the
United States. Volatility is measured as the standard deviation of the quarterly real GDP growthrate over a 10 years period (where the x axis in the graph denotes the end of that period), while
wealth is measured as the average deviations from trend for net worth of households and non
profit organization (from the Flow of Funds) over the same 10 years windows. The figure reveals
that periods when average net worth is high relative to trend, reflecting high prices for housing
and/or stocks, tend to be periods of low volatility in aggregate output (and hence employment andconsumption). Conversely, periods in which net worth is below trend tend to be periods of highmacroeconomic volatility. For example during periods ending in late 70s and early 1980s wealthis at its historical low and volatility is at its historical high, while periods ending during the late
1990s and early 2000s wealth is at its highest and volatility is at its lowest.
Figure 2 presents another piece of evidence that relates economic volatility and wealth, showingthat the three periods over the past century in which the US economy has been more unstable,
namely the 30s, the late 70s early 80s and the late 00s are all characterized by household net worth
below trend1
In this paper we argue that (exogenously given) fluctuations in wealth are an important factor
in determining the volatility of business cycles. We make the argument by developing a microfounded dynamic equilibrium model that contains elements of a traditional Keynesian frameworkin which economic fluctuations are driven by fluctuations in household optimism or pessimism.
The novel feature is that the scope for equilibrium fluctuations due to “animal spirits” depends
crucially on the value of wealth in the economy. When wealth is high the economy has a uniqueequilibrium and behaves neoclassically. When wealth is low, the economy becomes vulnerable toadditional confidence-driven fluctuations and hence is, in general, more volatile. In this case, there
is a potential role for public policies to stabilize demand.
Our model economy is populated by a large number of identical households, each of which
comprises many members. Competitive firms operate a linear technology that transforms employedworkers into a perishable consumption good. In addition to non-durable consumption, households
enjoy utility from durable housing, which is in fixed supply. Households commit to consumption
orders for their members. Then jobs are allocated by random matching in a decentralized labor
1

Household net worth is from the Flow of Funds from 1945 onward and has been calculated using historical sourceson stock values and housing prices for earlier periods, see the data appendix for more details

1

.08
WealthStandard Deviation of GDP Growth

.04
.00
.016
-.04

.014

-.08

.012
.010

Volatility

Household Net Worth (% devs from trend)

.12

.008
.006
.004
60

65

70

75

80

85

90

95

00

05

10

Note: Standard deviation of GDP growth are computed over 40 quarters rolling windows.
Observations for net worth are average over the same windows

Figure 1: Wealth and volatility

13
12
11
.4
10

.3
.2

9

.1
.0
-.1
-.2
1920

1930

1940

1950

1960

Log of Real Household Net Worth

1970

1980

Trend (3.2%)

1990

2000

2010

Deviations from Trend

Figure 2: Household net worth in US in the long run

2market, in which firms hire sufficient workers to fulfill their orders. The decentralized nature of thelabor market is important because it means that equilibrium output will be determined by desiredconsumption demand, rather than by desired labor supply, and because it allows for the possibilityof equilibrium unemployment.
Agents must finance their consumption orders using wage income, home equity, or non-collateralizedborrowing. Unemployment expectations matters not only because the expected unemployment rate
determines expected income, but also because if house prices are low the household anticipates thatmembers who do not find jobs will have to use expensive credit. The fact that consumption foreach member is committed prior to realization of the member’s idiosyncratic employment statusincreases the precautionary motive associated with perceived unemployment risk.
Our first result is to show that this environment allows for multiple equilibria in which households can collectively co-ordinate on a range of expectations about unemployment, each of whichturns out to be self-fulfilling. In particular, there is a range of values for house prices in which
the model has two steady states (with the same house price in each). In the optimistic steadystate, households expect low unemployment, are therefore not too concerned about credit costs for
unemployed workers, and set consumption demand high. Facing high demand, firms employ a large
fraction of workers, and the expectation of low unemployment is rationalized. In the pessimistic
steady state, households expect high unemployment. Because they do not want to commit to highconsumption given high idiosyncratic unemployment risk and costly credit, they set consumption
demand low. Facing low demand, firms hire few workers, and unemployment is in fact high, as
expected.
Precautionary saving in housing offers a way for households to self-insure against unemploymentrisk. The less wealth a household has, the more reliant the household will be on costly credit in
the event of unemployment. Thus the lower is household wealth, the more sensitive is consumption
demand to the expected unemployment rate. This increased sensitivity of demand to expectations
increases the range of unemployment rates that can be supported in a rational expectations equilibrium. To see this consider the extreme case in which households have no wealth. Then, if they
are maximally pessimistic and expect 100% unemployment they will set consumption to zero, and100% unemployment can occur in equilibrium. But if households have positive wealth they will
choose positive consumption even if they expect 100% unemployment. Firms must then hire a positive fraction of workers to fill these orders, and so 100% unemployment cannot be an equilibrium.
Thus the maximum magnitude of sun-spot driven equilibrium fluctuations will vary inversely withthe level of house prices.
3Home values in the model are endogenous equilibrium objects, and reflect both the fundamental
flow utility from home ownership and the liquidity value of being able to finance consumption outof home equity in the event of unemployment. Because this liquidity value is tied to the level of
unemployment, house prices themselves are indeterminate, and like the unemployment rate, canpotentially fluctuate in response to changes in expectations. However, for most of our analysis
we will explore what dynamics for unemployment are possible for alternative constant values forequilibrium house prices. We do this because in the data a large share of house price volatility is
at lower frequencies than typical business cycle fluctuations.
We further limit the set of values for house prices we consider by introducing as an additionalmodel element a fringe group of households that does not face unemployment risk. The presenceof this group establishes a lower bound on housing demand and thus on equilibrium house prices.
If this lower bound is sufficiently high, unemployed workers can finance consumption entirely outof home equity, and full employment is the only possible equilibrium.
We use the model to offer an interpretation of recent macroeconomic history. The Great Moderation was a time in which US house and stock prices were very high by historical standards. Highhousehold wealth levels in this period meant that the economy was robust in the sense that it was
not subject to large recessions induced by declines in confidence. However, the sharp declines inhouse and stock prices between mid 2007 and mid 2009 left the economy fragile, and vulnerable
to a confidence-driven recession. One possible “trigger” for a collective loss of confidence was thecollapse of Lehman Brothers in the Fall of 2008. We show that following a transitory sunspotinduced recession, equilibrium dynamics imply a slow recovery, even though fundamentals remainunchanged. Of course, fluctuations in consumer confidence are only one source of business cycles,
and over a longer history economic cycles in the United States likely have a number of causes aboveand beyond fluctuations in animal spirits.
The model has policy implications. We evaluate two specific policies. The first is a lump-sum
unemployment benefit, financed by a proportional income tax. This policy makes unemployment
less painful, and thereby reduces the sensitivity of demand to the expected unemployment rate.
A sufficiently generous benefit rules out sunspot-driven fluctuations and ensures full employment.
The second policy we consider is government consumption financed by lump-sum taxation, in thespirit of the 2009 stimulus plan. This policy also makes aggregate (private plus public) demandless sensitive to expectations, and thereby rules out equilibria with very high unemployment rates.
However, taxation also reduces asset values, which increases the sensitivity of demand to perceived
unemployment risk.
41.1

Related Literature

From a theoretical viewpoint, our paper is related to recent work by Guerrieri and Lorenzoni (2009),
Chamley (2010), and Farmer (2010). In both our model and Farmer’s output is demand-determined,
and asset prices play a critical role in determining demand. One difference is that agents in ourmodel face idiosyncratic risk and thus have a precautionary motive for saving, which is central todelivering a connection between the level of asset prices and the volatility of output. Guerrieriand Lorenzoni develop a model in which risk-averse agents trade in a decentralized fashion andface idiosyncratic risk. Their model recessions feature an increase in precautionary saving, as doours, but in their model an endogenous increase in precaution amplifies a fundamental aggregate
productivity shock, while in ours it is a self-fulfilling prophecy.
A challenge in constructing models in which demand-side factors play an important role in thatmany forces that tend to reduce desired consumption demand (e.g. lower asset values, greater
idiosyncratic risk) also tend to increase desired household labor supply. Hall (2005), Michaillat(2010) and Shimer (2012) have developed models with decentralized labor markets in which they
assume that the real wage does not fall (much) in response to a negative productivity shock, leading
to a large fall in vacancy posting and a surge in involuntary unemployment. These models lackclear microfoundations for wage formation. On the other hand, they offer a natural resolution to
the longstanding discrepancy between small microeconomic estimates for labor supply elasticities,
and the large macro elasticities implicit in the large movements in aggregate hours over the businesscycle (see, for example, Chetty et al., 2011). The resolution is simply that large falls in aggregate
hours during recessions do not reflect an unwillingness to supply labor, but instead indicate thatwages are “stuck” at too-high levels. In our model, the household is assumed to first choosea reservation wage, and then the firm only gets to decide whether or not to accept or reject a
potential match. Workers then always extract all the surplus from a firm-worker match and, givena linear technology, firms are always indifferent about how many workers to hire. The level ofdemand then effectively selects a particular employment rate.
We are not the first to argue for a link between asset values and volatility, but our mechanism
reverses the usual direction of causation. Others (see Lettau et al. 2008) have pointed out thathigher aggregate risk should drive up the risk premium on risky assets relative to safe assets. Lower
prices for risky assets like housing and equity then just reflect higher expected future returns onthese assets. In our model, asset prices are the primitive, and the level of asset prices determines
the possible range of equilibrium output fluctuations, i.e. macroeconomic volatility.

5

2

Model

There are two goods in the economy: a perishable consumption good, produced by a continuum ofidentical competitive firms using labor, and an durable asset, which is in fixed supply and which
we label housing. There are two types of households in the model, and a continuum of identicalhouseholds of each type. These types share common preferences, but differ with respect to the risk
they face: income for the first type is risky, while income for the second is not.
Each household of the first “risky” type contains a continuum of measure one of individuals. The
measure of firms is equal to the measure of risky households. Thus we can envision a representative
firm interacting with mass one members of a representative risky household. The price of theconsumption good is normalized to one in each period. The quantity of housing is normalized toone. The riskless type of household is measure zero, but its presence will establish a floor for asset
prices. The economy is closed.
Let st denote the current state of the economy, and st denote the history up to date t. In eachperiod, households of the risky type send out members to buy consumption and to look for jobs.
Employment opportunities are randomly allocated across individuals, and the consumption ordermust be specified before this allocation is realized. Thus, the optimal strategy is to send eachmember out with the same order c(st ) and an equal fraction h(st−1 ) of the assets the household
carries in the period. The fraction 1 − u(st ) of household members who find a job are paid a wage
w(st ) and use wage income and asset holdings to clear their consumption orders. The fraction u(st )who are unemployed pay for as much of their consumption order c(st ) as they can given assets on
hand, and if necessary borrow to pay the rest. Borrowing incurs intermediation costs which, forsimplicity, we model as a tax that depends on the amount borrowed. These taxes are rebated tohouseholds within the period as lump-sum transfers denoted T (st ). At the end of the period thehousehold regroups and pools resources, which determines the quantity of the asset carried into thenext period h(st ).
At the start of each period t households observe st , update st , and assign probabilities to future
sequences {sτ }∞τ =t+1 . We assume that all households form the same expectations.
Preferences for a household (exploiting the fact that each household member enjoys the same
consumption level) are given by
∞
X
t=0

βt

X


π(st )u c(st ), h(st−1 ), φ(st ) .

st6

where β is the discount factor, π(st ) is the probability of history st as of date 0, and φ(st ) is apotentially stochastic preference weight.
The household budget constraint for a risky household has the form:







ψ
2
c(st ) + p(st ) h(st ) − h(st−1 ) ≤ 1 − u(st ) w(st ) − u(st ) min p(st )h(st−1 ) − d − c(st ) , 0 + T (st )2z̄c(st ), h(st ) ≥ 0
The left hand side of the budget constraint captures consumption and the cost of net asset purchases.
The first term on the right hand side is household earnings, while the second is the cost of borrowing
for unemployed workers who use credit to pay for consumption. Note that this cost is quadraticand only applies to the fraction u(st ) of workers who are unemployed, and only if the household
sets the consumption order above the value of home equity. Home equity is the value of housing
owned by the household, p(st )h(st−1 ), minus an amount d that we think of as mortgage debt. The
size of credit costs is determined by the parameter ψ relative to average productivity z̄.
Note that h(st−1 ) was effectively chosen in the previous period. In the current period, given
aggregate variables u(st ), w(st ), p(st ) and T (st ), the choice for c(st ) implicitly defines the quantityof wealth carried into the next period h(st ).
The analogous budget constraint for the riskless household is identical, except that unemployment and transfers for this type are equal to zero.

2.1

Household’s problem

Consider the problem for the type that faces unemployment risk. Let µ(st ) be the multiplier on
the budget constraint at history st . Assuming the non-negativity constraints on c(st ) and h(st ) are
non-binding, the first order conditions with respect to c(st ) and h(st ) are:


ψ
t
t
t
t
t
t
β π(s )uc (s ) = µ(s ) 1 + u(s )b(s )
z̄



X
ψ
t
t
t+1 t
t+1
t+1
t+1
t+1
t+1
t+1
t+1
µ(s )p(s ) =π(s |s ) β uh (s ) + µ(s ) p(s ) + u(s )p(s )b(s )
z̄
t+1
s

where b(st ) denotes borrowing of the unemployed:b(st ) = maxc(st ) − p(st )h(st−1 ) − d , 0 .

7

(1)

(2)

Substituting (1) into (2)uc (st )p(st )1 + ψz̄ u(st )b(st )= βE|st uh (st+1 ) + uc (st+1 )p(st+1 )(3)This looks like a standard inter-temporal first order condition for a consumption-savings problem,
except the denominator of the left hand side indicates an additional motivation for saving whenunemployment necessitates borrowing: saving one additional unit of the asset is really cheaper thanthe price p(st ) because reducing current consumption reduces expected borrowing costs. Credit
costs are isomorphic to a tax on current (but not future) consumption at rate 1 + ψz̄ u(st )b(st ).
Under this interpretation, choosing lower c(st ) and thus lower b(st ) reduces the effective tax rate.
The analogous first order condition for the type that does not face unemployment risk isuĉ (st )p(st ) ≤ βE|st uĥ (st+1 ) + uĉ (st+1 )p(st+1 )where hats denote allocations for this type. The inequality here reflects the fact that, given thepreferences we will assume below, the type facing no unemployment risk will be at a corner in
equilibrium, with zero housing.

2.2

Production and Labor Markets

Each representative firm produces according the following linear technology:y(st ) = z(st )n(st )where n(st ) is the mass of workers employed by the representative firm, and z(st ) is potentiallystochastic productivity. In equilibrium u(st ) = 1 − n(st ). We now describe how equilibrium employment is determined.
Households first observe the aggregate state st and then give workers instructions about whatwages to accept, i.e. they specify a reservation wage w∗ (st ). Firms and workers meet in a decentralized labor market. A unit mass of workers meets each firm, where these meetings occur in arandom sequence throughout the period. Each firm takes as given the wage w∗ (st ), the price atwhich it can sell output (normalized to one), and decides whether or not to hire each successive
worker it meets. When a firm hires a worker it produces and sells the resulting output immediately.
The optimal strategy for the firm in this environment is to employ a worker if and only if
the worker’s reservation wage w∗ (st ) is less than or equal to the worker’s marginal product z(st ).
8

Understanding the firms’ incentives, a representative household will optimally assign its members
a reservation wage w∗ (st ) = z(st ). Recall that a lower reservation wage does not increase theprobability that a given household member will find a job, while a higher reservation wage would
guarantee non-employment.
Note that households make consumption decisions and firms make production plans given thesame information set and identical expectations.
We assume that z(st ) follows a first-order Markov process, with mean z̄ = 1.

2.3

Equilibrium

In some versions of the model, labor productivity zt and the preference for housing φt will be
sufficient statistics for all aggregate variables. In other versions, sunspot-driven fluctuations in
expectations will generate non-fundamental driven movements in consumption and house prices.
Thus we define the current aggregate state of the economy st = (zt , φt , ct , pt ) . [REVISIT THIS]
The distribution of housing wealth does not appear because we will focus on equilibria in which all
housing is owned by the risky household type, and in which each risky household is representative.
(In Section XX we will consider an example in which the distribution of wealth between types isallowed to vary). A symmetric equilibrium in this model is a process for st and associated decisionrules and prices n(st ), u(st ), w(st ), h(st ), T (st ) that satisfy, for all t and for all st :1.
w(st ) = w∗ (st ) = z(st )2.
n(st ) = 1 − u(st )3.
h(st ) = 1
4.
c(st ) = z(st )(1 − u(st ))5.
T (st ) =



ψ
2
u(st ) max c(st ) − p(st ) − d , 0
2z̄

9

6.
uc (st )p(st )1 + ψz̄ u(st ) max {[c(st ) − (p(st ) − d)] , 0}

=β

X



π(st+1 |st ) uh (st+1 ) + uc (st+1 )p(st+1 )

st+1

7.
uĉ (st )p(st ) ≥ βXπ(st+1 |st ) uĥ (st+1 ) + uĉ (st+1 )p(st+1 )

st+1

2.4

Discussion

In a symmetric equilibrium, each firm employs sufficient workers to satisfy demand: n(st ) =c(st )/z(st ). Thus, in this environment, the consumption order c(st ) determines employment n(st )and unemployment u(st ) = 1 − n(st ). If orders fall short of potential output, i.e., if c(st ) < z(st ),then labor supply will exceed labor demand, in the sense that all measure 1 of workers in eachhousehold are willing to work at any positive wage, while employment is determined by labordemand n(st ) = c(st )/z(st ) < 1.
In this environment, firms are on their labor demand curve. However, no single atomistic
household has an incentive to choose a lower reservation wage, becuase a lower wage will notincrease the probability of its members forming successful matches. Thus unemployment does
not exert downward pressure on wages, breaking the standard Walrasian adjustment process that
ultimately equates labor demand and labor supply in models with frictionless labor markets.
The model of the household we adopt is a simple way to introduce idiosyncratic risk and a
precautionary motive, without having to keep track of the distribution of wealth. We assumed thatthe household must choose commit to a consumption choice for each household member before
members’ idiosyncratic employment status is revealed. Had we instead allowed the household tosend members out with two contingent consumption orders, higher expected unemployment would
still strengthen the precautionary motive to save, but the effect would be much weaker, because
the household could reduce the cost of unemployment spells by instructing unemployed workers to
reduce spending rather than increase costly borrowing. In reality, large categories of consumption
are either impossible or very costly to reduce quickly in response to a negative income shock. It is
possible to eat at home rather than go out for dinner, but it is difficult to return an iPhone to theApple Store, and it is difficult to reduce housing related expenses without down-sizing to a smallerhome.
The economic logic for the quadratic credit cost is that in the event that an unemployed worker
is forced to borrow, he will exhaust cheap sources of credit first before turning to more expensive
10

sources - thus the marginal cost of credit should be increasing in the amount borrowed. For our
purposes a quadratic cost function is particularly tractable, but any exponent larger than unity
delivers qualitatively similar results.2

2.5

Preferences

We will assume the utility function is of the following separable quasi-linear formu(c, h, φ) = log c + φhGiven this utility function coupled with ĥ(st ) = 0 for all st , the inter-temporal first order condition
for the riskless type simplifies totp(s ) ≥ β

X

π(s

st+1

t+1

φ(st+1 ) + z(st+1 )−1 p(st+1 )|s )z(st )−1
t




(4)

Thus the presence of this type puts a floor under house prices.3
For the rest of the paper we will assume z(st ) = z̄ = 1 for all st . We will also assume φ(st ) = φ
for all st . However, we will compare equilibria with alternative constant values for φ.

3

Steady States

In steady state, the expression for the asset price floor above simplifies to
p≥p=

β
φ.
1−β

Steady state consumption is given byc = 1 − u.
Thus a sufficient condition for unemployed agents to be able to finance consumption out of homeequity at any unemployment rate in steady state isp−d≥1
which is satisfied if
φ ≥ φ̄ =23

1−β(1 + d)β

A linear cost function would introduce a kink in the agent’s budget set.
Note that with h(st ) = 1 the inter-temporal first order condition for the risky household type would be identical

if preferences were given by u(c, h, φ) = log c + φ log h. Thus it is sufficient to assume linearity in preferences for theriskless type.

11

3.1

Full employment steady state with high house prices

Claim: If φ ≥ φ̄, the only possible steady state is p = p, u = 0.
Proof: The steady state version of the risky type’s intertemporal first order condition isp(1 − u)= βφ + βp =p(1 − u)βφ(1 − u)(1 − β)(5)Given the price floor
p≥p=

β
φ
1−β

the only possible steady state is p = p, u = 0.
Note that this uniqueness result hinges on the presence of the riskless household type. Without
this type, there would be a continuum of steady states with unemployment rates between zero andone, with each unemployment rate corresponding to a different steady state asset price as given byeq. 5 (see Farmer 2010). The presence of the riskless type puts a floor on the asset price, which
effectively establishes a floor for steady state consumption demand and output.

3.2

Multiple steady states with low house prices

Now consider the case φ < φ̄, so that demand for housing by the riskless type is not strong enoughto drive house prices to a level at which borrowing is never necessary.
Now steady states are solutions (c, u, p) to the following equations
pc−1= β φ + pc−1
1 + ψu max {[c − (p − d)] , 0}

(6)

c=1−u
β
p≥p=
φ
1−β

Claim: Any steady state with positive unemployment must feature costly credit: u > 0 =⇒ c >p − d.
Proof: Suppose, contrary to the claim, that u > 0 and c ≤ p − d. Then the price that solves
the inter-temporal FOC would be
p = pF (u) =βφ(1 − u) < p1−β12where pF (u) is the “fundamental” steady state price given u. But p < p contradicts p ≥ p whichmust hold in any steady state.
The logic for this result is that in any steady state with positive unemployment, households
facing unemployment risk have lower expected income than households who do not face that risk.
For the risky households to be nonetheless willing to pay more for housing, it must be that housing
has additional value as a source of liqudity for the risky type. This in turn implies that in steadystate unemployed agents must be using costly credit, so that the additional liquidity associatedwith home equity is priced.
Claim: There exists a steady state with positive unemployment if and only if
φ < φ̄ and ψ ≥ ψ̄ =(1 − β)2(1 − β)(1 + d) − βφ

Proof: [TO BE ADDED]The logic for the threshold ψ̄ is as follows. Suppose we start with p = p and u = 0, and consider
how the steady state asset price changes in response to a marginal increase in unemployment. On the
one hand, higher unemployment reduces expected income, reducing fundamental housing demand
and the fundamental component of the price pF (u). On the other hand, increasing unemployment
raises the liquidity value for housing. At ψ = ψ̄ the two effects exactly offset, and a marginalincrease in unemployment is consistent with the same steady state asset price. For ψ > ψ̄, theliquidity effect dominates, and a marginal increase in unemployment necessitates an increase in
the steady state asset price: i.e.

∂p∂u

> 0 at p = p and u = 0. For higher unemployment rates,

the fundamental effect must eventually dominate, and by continuity, there must be at least one
additional equilibrium at p = p and u > 0.

3.2.1

Simple example with φ = 0

For φ = 0, the set of solutions to these equations is particularly simple. This is a model in which
housing offers no utility, and no financial return, and is only held because it offers liquidity andreduces borrowing costs. From 6 steady state consumption demand is given by
c=

ρ
+p−d
ψu

13

where ρ = 1−ββ is the rate of time preference. Thus steady state demand is increasing in home equityp − d, and decreasing in unemployment risk u. Note that positive wealth establishes a positive floor
on consumption demand, even if the expected unemployment rate is 100%. As the unemployment
risk u is reduced, a higher steady state borrowing level for unemployed workers c−(p−d) is required
for agents to maintain constant consumption over time.
In any steady state, the inter-temporal motive to borrow plus the precautionary motive to save
add up to a constant desired level of asset holdings equal to p. Equivalently steady state demand
must equal steady state supply:ρ+p−d=1−uψuThis is a quadratic equation with potentially two interior solutions:


r
1
ρ
2
(1 − (p − d)) ± (1 − (p − d)) − 4u=2ψThis equation has two interior solutions as long as ψ > ψ̄ = 1−β1+d . At both steady state unemployment rates, the household chooses to set c = 1 − u. Note that the ratio of wealth to expected
income differs across the two steady states. In both steady states, wealth is the same, and equal
to p, while expected income differs. In the high unemployment steady state, one can interpret thehigher steady state wealth to income ratio as reflecting a greater precautionary demand for savingin the face of greater unemployment risk.

3.2.2

Example with φ > 0

For φ > 0 solving for steady state unemployment rates in closed-form is slightly more complicated,because the equation defining steady states is now a cubic in u. However, it is straightforward tocharacterize the set of steady states numerically. We now plot the set of steady states for ψ = 1,
β = 0.9, φ = 0.05 and d = 0.1. Note that this parameter configuration satisfies φ < φ̄ = 0.1 andψ > ψ̄ = 0.15, so there are steady states in which u > 0 and p > p̄ = 0.45. Figure 3 shows theequations defining steady state consumption demand (curved red line) and supply (straight blackline) given p = 0.6.
It is clear that there are two steady states here, one with low, and one with higher unemployment. In the low unemployment equilibrium wealth is low relative to consumption, but thehousehold does not want to increase saving because unemployment risk is low. In the high unemployment equilibrium, unemployment risk is high, but the household does not want to increasesaving because wealth is already high relative to consumption.
14

c

1.2

1.0

0.8

0.6

0.4

0.2

0.0
0.0

0.1

0.2

0.3

0.4

0.5

0.6

0.7

0.8

0.9

1.0

u

is clear that there are two steady states here, one with low, and one with higher unemployment.
the low unemployment equilibrium Figure
wealthis lowstates
relativeto0.6.
consumption, but the household
3: Steadyfor p =

oes not want to increase saving because unemployment risk is low. In the high unemploymentuilibrium, unemployment risk is high, but the household does not want to increase saving because

ealth is already high relative to consumption.
The plot above shows the set of steady states for a particular price  The next plot shows thet of steady states for all  ≥ 

p

0.7

15

with credit frictionuilibrium, unemployment risk is high, but the household does not want to increase saving because

ealth is already high relative to consumption.
The plot above shows the set of steady states for a particular price  The next plot shows thet of steady states for all  ≥ p

0.7

with credit friction
0.6

0.5

pbar
0.4

without credit friction

0.3

uL
0.0

uH
0.1

0.2

0.3

0.4

0.5

0.6

u

14

Figure 4: Steady states for p = 0.6.
Figure 3 shows the set of steady states for a particular price p while Figure 4 shows the set ofsteady states for all p ≥ p.
The green horizontal line here is p = p̄, and the hump-shaped black line shows unemployment
rates that satisfy the inter-temporal first order condition and market clearing at prices p ≥ 0, i.e.
solutions tohip (1 − u)−1
= β φ + p (1 − u)−1 .
1 + ψu [(1 − u) − (p − d)](7)

It is clear that for all p such that a steady state exists, there are two steady state unemployment
rates given this particular parameter configuration. The distance between the two steady state
unemployment rates is decreasing in p.
The red line in the picture shows the price the household would be willing to pay absent theliquidity value for housing, i.e. the solutions tohip (1 − u)−1 = β φ + p (1 − u)−1 .
Thus for a given steady state unemployment rate, the red line shows the “fundamental” asset
16

value pF (u), while the vertical distance between the black and red lines measures the “liquidity”
value of housing (which is zero when u = 0).
The figure also shows the two steady states for p = 0.6, the steady state price assumed for theprevious figure. In the low unemployment equilibrium (uL ) the fundamental share of house value ishigh relative to the liquidity value, while in the high unemployment steady state (uH ) the opposite
is true.

4

Dynamics

We now want to consider dynamics. Suppose that p(st ) = p > p. The inter-temporal FOC is (using
the resource constraint to substitute out consumption)
−1
h
 i
1 − u(st )φt+1 −1
t
=
β
+
βE
1
−
u(s
)
.
|s
1 + ψu(st ) max {[(1 − u(st )) − (p − d))] , 0}p
−1
Let x(st ) = 1 − u(st ), so u(st ) = 1 − x(st )−1 . Then we can rewrite this as
E|st x(st+1 ) =φx(st )−β [1 + ψ (1 − x(st )−1 ) max {[x(st )−1 − (p − d))] , 0}] p

or, more compactly, as
E|st x(st+1 ) = F (x(st ))(8)

Suppose we now introduce a “sunspot”, vt , where vt+1 (part of the date t + 1 state, st+1 ) issymmetrically distributed with mean zero with a support [−εt+1 , +εt+1 ] defined by εt+1 = G(x(st )),and wherex(st+1 ) = E|st x(st+1 ) + vt+1 (st+1 )The assumption that vt+1 has mean zero is a pre-requisite for rational expectations. The assumptionthat the distribution for vt+1 is symmetric could be relaxed.
Given this specification for a sunspot shock, we can re-write the inter-temporal FOC asx(st+1 ) = F (x(st )) + vt+1 (st+1 )Thus the F function tells us the expected part of x(st+1 ) while the sunspot vt+1 tells us the impactof the impact of the sunspot shock.
Absent any fundamental shocks (shocks to productivity or preferences) we can define equilibrium
recursively, with the current state being xt , and the shock being vt+1 . (The current sunspot shock17

u(t+1)-u(t) 0.03

0.02

0.01



uL



uH



0.00
0.1

0.2

0.3

0.4

0.5

0.6

0.7

0.8

0.9

1.0

u(t)

-0.01

Figure5: Unemployment
Dynamics
Let  and  denote the low and highunemployment
steadystates. The plot indicates that theow unemployment steady state is locally dynamically stable: if unemployment starts out below
vt is redundant as a state because xt is a sufficient statistic for current unemployment, and vt does

rise,vt+1
while
it startsaboveis(butbelow
 , unemployment
not helpwill
forecast
givenifthat
the sunspot
shock
iid overtime.) ) unemployment will fall.

Because this steady state is dynamically stable, we can introduce sunspot shocks that will generatesunspot shocks
fluctuations in4.1the Noneighborhoodof  t )) =The high Suppose
unemployment
steadystate
is 0,notstable.
If) =unemployment
first that G(x(sεt+1 =
so thatx(st+1
E|st x(st+1 ) . starts above  , it will

ncrease towardsItmaximum
unemployment,in dynamics
expectedforterms(thekink xin
the thus
pathto reflects
is straightforward
to compute thext given
an initialplot the the
0 , anddynamics
unemployment:
point at whichcorresponding
the householdstopsforusing
costly credit). Note that any such paths are not equilibria,−1 with zero income−1and consumption,
because in the limit they imply
that households will(1end− u)upφ0!

∆u = u − u = 1 −β (1 + ψu max {[(1 − u) − (p − d))] , 0})
which cannot be optimal given positive wealth.

−

p

−u

plots ∆u as a function of u, assuming p = 0.6.
Note that Figure
costly5credit
is being used at each point along any equilibrium path for unemployment

uL and uH denote the low and high unemployment steady states. The plot indicates that thecorresponding toLet
diﬀerent
initial unemployment rates 0 ∈ [0  ]. The logic is as follows. First, we
low unemployment steady state is locally dynamically stable: if unemployment starts out below

have argued that the costly credit is used in all steady states with positive unemployment, and is
uL , unemployment will rise, while if it starts above uL (but below uH ) unemployment will fall.

thus being used at the high unemployment steady state  . Second, given that (1 −  )  ( − ),the credit constraint must also be binding at all lower18unemployment rates, since these correspondBecause this steady state is dynamically stable, we can introduce sunspot shocks that will generate
fluctuations in the neighborhood of uL .
The high unemployment steady state is not stable. If unemployment starts above uH , it will
increase towards maximum unemployment, in expected terms (the kink in the path reflects thepoint at which the household stops using costly credit). Note that any such paths are not equilibria,
because in the limit they imply that households will end up with zero income and consumption,
which cannot be optimal given positive wealth.
Note that costly credit is being used at each point along any equilibrium path for unemployment
corresponding to different initial unemployment rates u0 ∈ [0, uH ]. The logic is as follows. First, wehave argued that the costly credit is used in all steady states with positive unemployment, and isthus being used at the high unemployment steady state uH . Second, given that (1 − uH ) > (p − d),the credit constraint must also be binding at all lower unemployment rates, since these correspondto higher consumption levels.

4.2

Introducing Sunspots

When we introduce sunspots, a range of paths become possible. For a particular current xt ,xt+1 ∈ [F (xt ) − G(xt ), F (xt ) + G(xt )]The bounds G(xt ) have to be such that xt+1 ≤ (1 − uH )−1 and xt+1 ≥ 0, so that the unemployment rate remains between between zero and uH . The reason xt+1 can never exceed (1 − uH )−1(equivalently ut+1 cannot exceed uH ) is that such realizations would make explosive paths possible(for example, vt+τ = 0 for all τ ≥ 2.).

5

Review: Asset Prices and Volatility

Recall that the starting point for this paper is the strong positive empirical correlation between thelevel of US household wealth and US macroeconomic volatility. We now collect together the various
theoretical results we have established corresponding to the relationship between asset prices andoutput:1. First, if the taste for housing is strong (φ ≥ φ̄) or if credit is cheap (ψ ≤ ψ̄) then the only
equilibrium is permanent full employment.
19

2. Second, if the taste for housing is weak (φ < φ̄) so that home equity is inadequate to financeconsumption of the unemployed and if, in addition, credit is expensive (ψ > ψ̄) then themodel has two steady states for the same house price p. The unemployment rate in the highunemployment steady state uH is decreasing in p.
3. Third, given low house prices and expensive credit, and absent expectational errors, for any
possible steady state price p ≥ p, the set of equilibria is as follows. First, for any initial
unemployment rate u0 ∈ [0, uH ) there is an equilibrium path in which the unemployment
rate steadily converges to uL . Second, there is an equilibrium in which the unemployment
rate is initially uH and remains always at uH .
4. Fourth, because the low unemployment steady state is dynamically stable, non-fundamental
sunspot shocks can generate fluctuations in unemployment. Thus for any p ≥ p and any
ut ∈ [0, uH ) sunspot shocks can move the economy to any ut+1 ∈ [0, uH ) (in expected terms
unemployment evolves according to 8).
5. Finally, combining points 1, 2 and 4 and assuming costly credit, the range of equilibrium
unemployment rates [0, uH ) is decreasing in the steady state house price p. For high enoughp (i.e. φ ≥ φ̄) the only possible unemployment rate is u = 0. For lower values for p (i.e.
φ < φ̄) unemployment can fluctuate between 0 and uH . Moreover, since uH is declining in p
the range of equilibrium unemployment rates and thus the maximum size of sunspot shocks,
is decreasing in p.

6

Microeconomic evidence

As discussed above, when wealth is low demand (and hence output) in our model can fall in response
to a negative shock to expectations. Low wealth implies a strong precautionary motive and thisleads to a large consumption fall in response to higher perceived unemployment risk, thereby making
the expectation of higher unemployment self-fulfilling.
In this section we present some direct evidence for the first part of this mechanism using micro
data.
Consider in particular two households, one with low wealth and the other with high wealth,which face the same increase in unemployment/income risk. Our theory suggests that the low
wealth household should decrease its consumption more than the high wealth household. To test

20

this prediction we use data from the Consumer Expenditure (CE) Survey, which is the only US
data set that contains information on household-level wealth, expenditures and income. Households
in the CE survey are interviewed for a maximum of four consecutive quarters. Households reportconsumption expenditures in all four interviews, report income information in the first and lastinterview, and report wealth information in the last interview only. We use CE data from thefirst quarter of 2005 to the first quarter of 2011 and we select households for which we have four
consumption expenditure observations, two income observations and one wealth observation.
The goal is to compare changes in consumption expenditures during the course of the GreatRecession for wealth rich versus poor households, controlling for potentially different income trends
across the groups. It is important that we measure changes in expenditures using the same households, rather than comparing the average consumption of different sections of the wealth distribution at different points of time, as changes in moments of the cross sectional distribution mightreflect changes in composition of the cross-sections and not actual changes in expenditures. To
measure actual expenditure changes we exploit the limited panel dimension of the CE survey.
In particular, we first rank households in each survey quarter by net worth relative to averagequarterly consumption expenditure, which we use as a proxy for permanent income. Net worth
here includes net financial wealth plus housing wealth net of all mortgages (including home equity
loans). We then construct two wealth groups in each month of the survey, using the medianas the break-point. We compute aggregate nine-month consumption (income) growth for eachgroup as the difference between aggregate 4th interview consumption (income) less aggregate 1st
interview consumption (income). Note that we are using the exact same set of households tomeasure consumption and income growth. Finally we using a standard weighting scheme to convert
these observations on monthly growth rates to a quarterly frequency, assuming constant growth
between interview dates.
Before comparing changes in expenditures across groups, we compare aggregate consumption
in our CE sample to a conceptually-similar definition of consumption from the National Income
and Product Accounts (NIPA). In particular we take aggregate NIPA consumption expenditureminus the following categories: housing and utilities, health care, and financial services.4 . Figure
6 compares the CE and NIPA series, both of which are real, per-capita measures. The timing anddepth of the Great Recession are broadly similar across the two measures, although the extent of
the recovery in expenditures is much weaker in the CE than in NIPA.
4

We exclude the categories for which the matching of the CE with NIPA is particularly poor

21

Aggregate real consumption expenditures per capita
1.05
1.03
1.01
2005q1=1

0.99
0.97
0.95
0.93

NIPA

0.91

CE

0.89
0.87

2005‐I
2005‐II
2005‐III
2005‐IV
2006‐I
2006‐II
2006‐III
2006‐IV
2007‐I
2007‐II
2007‐III
2007‐IV
2008‐I
2008‐II
2008‐III
2008‐IV
2009‐I
2009‐II
2009‐III
2009‐IV
2010‐I
2010‐II
2010‐III2010‐IV
2011‐I

0.85

Figure 6: Aggregate real consumption expenditures per capita
Table 1 reports some characteristics of the two groups. First the table indicates that withrespect to demographics the wealth poor group appears to be composed by younger, less educatedand poorer (in terms of income ) households. The table also shows that the differences in average
net worth across the different groups are large: the median per capita household wealth in thepoorest group is close to 0 while the corresponding value for the rich group quartile exceeds 60000
2005 dollars.
Most important though, for our purposes, is the comparison of income and consumption growth
for the groups. The table shows that although the wealth poor experience a slightly stronger income
growth than the wealth rich, they experience a substantially stronger reduction in consumption
expenditures (-5.6% v/s -3.1%). We view this as prima-facie evidence that the level of wealth is amajor factor, independent from income, in determining demand response in a turbulent time.

22

Table 1. Characteristics of two wealth groups, 2005.1-2011.1
Wealth Group0-50 50-100
Sample size
8864
8873
Average age of head
41.4
46.9
Percent of heads with college
25.7
40.5
Average household size
2.9
2.8
Per capita real net wealth (2005$)
Mean
1498 119796
Median238
63162
Average per capita after tax income (2005$)
Level
22117
32811
Growth rate
-0.3%
-1.0%
Average per capita consumption expenditures (2005$)
Level
9353
11252
Growth rate
-5.6%
-3.1%
We analyze the issue in more detail as figure 7 plots (annualized) growth rates of per capita
real consumption for each of our four wealth groups from the 4th quarter of 2005 through the 1th
quarter of 2011 while figure 8 plots the change in consumption rates (i.e. consumption expenditure
over after tax total income) for the two groups. These 2 figures tell a clear story. The first suggeststhat the the wealth-poor group reduced consumption sooner and most periods more sharply than
the wealth rich. The second suggests that the relative reduction in consumption expenditures of
the wealth poor throughout the recession is not just driven by a poor relative income growth by thewealth poor but rather by an increasing saving (reduced consumption rate). Our theory suggeststhat this increase in relative saving rate of the wealth poor is the result of the strengthening of
their precautionary motive to save, in response to higher unemployment risk.

23

Change in consumption rate
‐0.01
2005q4
2006q1
2006q2
2006q3
2006q4
2007q1
2007q2
2007q3
2007q4
2008q1
2008q2
2008q3
2008q42009q1
2009q2
2009q3
2009q4
2010q1
2010q2
2010q3
2010q4
2011q1‐0.05

2005q4
2006q1
2006q2
2006q3
2006q4
2007q1
2007q2
2007q3
2007q4
2008q1
2008q2
2008q3
2008q42009q1
2009q2
2009q3
2009q4
2010q1
2010q2
2010q3
2010q4
2011q1

Growth in consumption expenditures
0.15

0.1
Wealth poor

Wealth Rich

0.05

0

‐0.1

‐0.15

Figure 7: Growth in consumption expenditures for rich and poor

0.02

0.01

0

‐0.02

‐0.03

Wealth poor

‐0.04

Wealth Rich

‐0.05

Figure 8: Changes in consumption rates for rich and poor

24

1.1

‐3
Net Worth Price (real, rel. to 2.1% trend)‐4

Durable Cons (real, pc, rel to 2.1% trend)

1.0

‐5

Unemployment Rate (negative(negative, right axis)
0.9

6
‐6
‐7
‐8

0.8

‐9
9
‐10

0.7

‐11

2011‐IVV

2011‐IIII

2011‐II

2011‐I

2010‐IV

2010‐III2010‐II

2010‐I

2009‐IV

2009‐III

2009‐II

2009‐I

2008‐IV

2008‐III

2008‐II

2008‐I

2007‐IV

2007‐III

2007‐II‐12
2007‐I

0.6

Figure 9: Asset prices, Consumption and Unemployment

7

The Great Recession

The key characteristics of the Great Recession were a sharp fall in asset prices, accompanied bya sharp fall in spending, and a rise in unemployment. Since the recession officially ended in mid
2009, the subsequent recovery has been slow.
Figure 9 shows timepaths for (i) the price of net worth, (ii) durable consumption, and (iii) the
unemployment rate over a five year period between the first quarter of 2007 and the last quarterof 2011.5 Asset prices fall 30% relative to trend in the first two years of the sample, while durables
5

A nominal net return series for net worth is constructed from the Flow of Funds as household and non-profit

sector holding gains on assets stated at market value (Table R100, line 9) divided by previous quarter net worth(Table B100, line 43). A price index is created from this series by deflating by the GDP deflator. The series plotted
for the real price of net worth and real per-capita durable consumption are deviations from a constant 2.1% trend,
the average growth rate of GDP per capita in the 1947-2007 period.

25

1.1

‐3

House Price (real, rel. to 2.1% trend)

1.0

‐4

Stock Price (real, rel. to 2.1% trend)‐5

Unemployment Rate (negative, right axis)

0.9

‐6
0.8

‐7

0.7

‐8
‐9
9

0.6
‐10
0.5

‐11

2011‐IV

2011‐III

2011‐II

2011‐I

2010‐IV

2010‐III2010‐II

2010‐I

2009‐IV

2009‐III

2009‐II

2009‐I

2008‐IV

2008‐III

2008‐II

2008‐I

2007‐IV

2007‐III

2007‐II‐12
2007‐I

0.4

Figure 10: Housing prices, stock prices and unemployment
consumption falls around 20%. Note that the fall in asset prices precedes the fall in consumer
spending, which in turn leads the fall in the unemployment rate. Figure 10 shows price series
for the two key components of net worth: house prices and stock prices. This figure shows thatthroughout 2007 house prices were already falling steadily relative to trend. In contrast, the fall instock prices was concentrated in 2008, and the rise in unemployment between mid 2008 and mid
2009. Thus a sharp fall in house prices precedes the falls in consumer spending and the rise in
unemployment. This fall in house prices drove the ratio of per capita home equity to per capita
annual disposable income from a post-War high of 1.61 in the first quarter of 2006 to 1.19 by the
fourth quarter of 2007, and to a post-War low of 0.70 by the end of 2011.
We now show that our model can generate dynamics that qualitatively resemble those describedabove. In the context of the model we interpret the events of the Great Recession as follows. Before
2006 the economy was robust in that the demand for housing was strong (φ > φ̄) and thus there
was no scope for expectations-driven cycles. Then, during 2006 and 2007, there was a fall in φ, the26

preference weight on housing, that left the economy fragile and vulnerable to a confidence-driven
recession. In 2008 a negative aggregate confidence shock, perhaps triggered by the collapse of
Lehman Brothers then led to a severe recession.
Figure 10 shows the dynamics for a simulation of the model along the lines just described. At
date t = −6 there is a permanent shock to preferences that reduces φ from its initial high value
φ0 > φ̄ to a new lower value φ1 = 0.05 < φ̄. All other parameters are set to the same values asin the previous figures. From t = −6 onwards, we assume the equilibrium house price is constantat p = 0.6. Recall that at this price, instead of a unique full employment steady state, the modelhas two steady states, both with positive unemployment. To construct the figure, we assume thatprior to date t = 0, the economy converges, with no surprises, towards the low unemployment
steady state. Then, at t = 0, a one-off expectational shock generates a sharp fall in spending andan associated sharp rise in unemployment. Fearing high unemployment, households expect higher
borrowing costs, and cut consumption orders to reduce credit costs. In aggregate this decline indemand does indeed translate into higher unemployment. After t = 0 the economy is hit by nofurther shocks, and the path for unemployment (the blue line) traces out the dynamics implied by
Figure 5 below.
Note that in response to the negative sunspot shock, households cut back consumption, eventhough they expect positive income and consumption growth looking forward. Moreover, households have not experienced any loss in wealth (by assumption p is held fixed). The reason they
nonetheless cut consumption is that higher unemployment risk generates a stronger precautionary
motive to save. In fact this precautionary motive is so strong that positive expected consumption
growth and an associated inter-temporal motive to dis-save is required to prevent a rise in house
prices. After the sharp initial contraction, the economy gradually converges back towards the low
unemployment steady state. In this recovery phase, the precautionary motive to save gradually
declines, and so does expected income and consumption growth, such that the desired amount ofhousehold saving remains constant and equal to p.

8

PolicyTO BE COMPLETED

27

1.2
1

Unemployment

Stock Prices

House Prices

0.8
0.6
0.4
0.2
0
‐9 ‐7 ‐5 ‐3 ‐1 1 3 5 7 9 11 13 15 17 19 21 23 25 27 29
Preference Shock at t=‐6, Sunspot Shock at t=0
Figure 11: Model’s prediction28

9

Extension to incorporate a centralized labor market

The crucial model assumption that opens the door to multiple equilibria is the decentralized labormarket. With a conventional centralized labor market, absent a utility cost of working, all agentswould choose to work at any positive wage, and full employment would be the only equilibrium.
The goal of this section is to present a model somewhere in between the baseline model, in
which labor supply plays no role and the real wage does not move in response to changes in theunemployment rate, and the alternative flexible centralized labor market model, which cannot
generate unemployment.
Suppose there are two sectors producing two different goods, c1 and c2 , using linear technologies.
Good c1 is produced by firms who hire workers in a centralized labor market, while good c2 is
produced by firms who hire in the decentralized fashion described in the baseline model.
Suppose preferences areu(c1 , c2 , h, φ) = λ log c1 + (1 − λ) log c2 + φh
The two goods are sold on a centralized market at prices p1 and p2 , where we normalize thelatter to one, as in the baseline model. The household chooses the fraction κ of its members tosend to work in the centralized market. Wages in the two markets are w1 and w2 .
All workers sent to the sector 1 find jobs that pay w1 , while fraction 1 − u of the workers sent
to sector 2 find jobs paying w2 . In both sectors the sector-specific value of the marginal productis equal to the sector wage. In equilibrium the household must be indifferent between sending an
additional worker to either sector.
The household budget constraint is now(p1 c1 + c2 ) + p(h0 − h) = κw1 + (1 − κ)(1 − u)w2ψ
− (1 − κ)u max {[(p1 c1 + c2 ) − (ph − d)] , 0}2 + T.
2
Note that from the perspective of the budget constraint the two types of consumption aretreated symmetrically. Note also that workers sent to sector 2 may end up unemployed, which adds
to potential credit costs.
Taking first-order conditions with respect to c1 , c2 , and κ givesc2
p1 (1 − λ)
=
c1
λ
29

and
w2 =

w1
u
ψ
+
max {[(p1 c1 + c2 ) − (ph − d)] , 0}2(1 − u)2 (1 − u)(9)This is quite intuitive. It says that there must be an equilibrium wage premium in sector 2 thatcompensates for both the difference in job finding rates - the first term - and the extra credit risk
from working in sector 2 - the second term. An interesting implication is that the wage differential
between the two sectors must be increasing in the unemployment rate. This fits with the notionthat relative wages for centralized labor market jobs like pizza delivery and fruit picking fall inrecessions.
Suppose the production functions are
c1 = κ

(10)

c2 = (1 − κ)(1 − u)
The respective sector-specific wages are thenw2 = p 2 = 1

(11)

and
w1 = p1 =(1 − κ)(1 − u) λc2 λ=.
c1 1 − λ
κ
1−λ

(12)

This last equation says that the relative wage in the centralized sector will be higher: (1) thestronger is the relative taste for good 1, (2) the smaller is the fraction of workers sent to thecentralized sector, and (3) the lower is the unemployment rate in the decentralized sector.
We can now go back to the labor-sector-choice-indifference condition to solve for the equilibrium
value for κ, given u and p. Substituting 11 and 12 into 9 along with 10 gives(1 − κ) λ
ψ
u
1=
+
max
κ 1−λ
2 (1 − u) 2(1 − κ)(1 − u)− (p − d) , 0
1−λ

(13)

Given u and p, this equation implicitly defines a solution for κ. Absent credit costs (ψ = 0) thesolution is simply κ = λ. Why is the unemployment rate irrelevant in this case? The intuition isthat given Cobb-Douglas preferences, holding fixed κ (at κ = λ) a higher unemployment rate andlower associated output of good 2 translates automatically into a lower relative relative price ofgood 1 and thus a lower relative wage in the centralized sector. This decline in the wage in the“safe” sector exactly offsets the decline in the job finding probability in the “risky” sector, and thehousehold optimally maintains the same division of job seekers between the two sectors.
30

When ψ > 0 and unemployed agents are using credit, the unemployment rate factors into the
optimal choice for κ. In particular, the fraction of household members in the centralized market κwill be increasing in the unemployment rate. Intuitively a greater relative supply of good 1, thecentralized market good, is required to increase the equilibrium wage differential between the two
sectors, which compensates for the extra credit costs that unemployed workers in the decentralized
sector will pay.
We have not yet addressed the main question of interest, which is whether the introduction of acentralized labor market fundamentally changes the nature of equilibrium dynamics that can arisein the model. The answer is no.
The inter-temporal first-order condition for housing is essentially unchanged relative to thebaseline model. Specifically, assuming a constant house price, it is now
 
φ
c−1
2
= β + βE c−1
2
1 + ψ(1 − κ)u max {[(p1 c1 + c2 ) − (p − d)] , 0}pwhere c2 = (1 − κ)(1 − u) and κ is the implicit function of u and p described in 13. Thus the key
equilibrium condition defining the equilibrium dynamics for unemployment is very similar to theone for the baseline model, the only difference being the presence of κ.
The nice thing about the model is that the parameter λ controls the overall size of labor market
frictions: as λ moves from zero to one, the economy moves from our original model to a Walrasian
one.

10

Conclusions

TO BE ADDED

References[1] Benito, A. (2006) “Does Job Insecurity Affect Household Consumption?”, Oxford Economic
Papers 56.
[2] Chamley, C. (2010) “Self-fulfilling Traps with Money as a Medium of Exchange” Working
paper.

31

[3] Chetty, R., A. Guren, D. Manoli, and A. Weber (2011) “Are Micro and Macro Labor Supply
Elasticities Consistent? A Meta-Analysis of Extensive Margin Elasticities” NBER Working
Paper 16729.
[4] Cooper, R., and A. John (1988), “Coordinating coordination failures in Keynesian models.”
Quarterly Journal of Economics 103 (3), 441-63[5] Corsetti, G., A. Meier and G. Muller (2010), “What determines government spending multipliers?”, Working paper[6] Farmer, R. (2010), “Confidence Crashes and Animal Spirits”, Working paper[7] Guerrieri V. and G. Lorenzoni (2009) “Liquidity and Trading Dynamics”, Econometrica 77(6).
[8] Hall, R.E. (2005), “Employment Fluctuations with Equilibrium Wage Stickiness”, American
Economic Review 95(1), 50-65.
[9] Kocherlakota, N. (2009), “Bursting Bubbles: Consequences and Cures”, Working paper[10] Lettau, M. Ludvigson, S., and J. Wachter (2008), “The Declining Equity Premium: What
Role Does Macroeconomic Risk Play?” Review of Financial Studies, 21, 1653-1687[11] Mian, A., Rao, K., and A. Sufi (2011), “Household Balance Sheets, Consumption, and theEconomic Slump”, Working paper.
[12] Michaillat, P. (2012), “Do Matching Frictions Explain Unemployment? Not in Bad Times”,
American Economic Review[13] Shimer, R. (2012), “Wage Rigidities and Jobless Recoveries”, Journal of Monetary Economics

32