Income Risk and Aggregate Demand over the Business Cycle

Abstract

This dissertation consists of three essays on income risk and aggregate demand over the business cycle, each addressing an aspect of the Great Recession. The first chapter reframes the standard liquidity trap model to illustrate the costly feedback loop between idiosyncratic risk and aggregate demand. I first show that a liquidity trap can result from excess demand for precautionary savings in times of high uncertainty. Second, I show that the output and welfare costs of the ensuing recession depend crucially on how the drop in demand for output is translated into a reduction in demand for labor. Increased unemployment risk compounds the original rise in idiosyncratic productivity risk and reinforces precautionary motives, deepening the recession. Third, I show that increasing social insurance can raise output and welfare at the zero bound. I decompose these effects to distinguish the component unique to the liquidity trap environment and show that social insurance is most effective at the zero bound when it targets the type of idiosyncratic risk households face, which in turns depends on the labor market adjustment mechanism. The second paper offers a novel model of the connection between the consumer credit and home mortgage markets through an individual’s credit history. This paper introduces a novel justification for the home mortgage interest deduction. In an economy with both housing assets and consumer credit, the mortgage interest deduction is modeled as a subsidy for the accumulation of collateralizable assets by households who have maintained good credit. As such, the subsidy loosens participation constraints and facilitates risk-sharing. Empirical evidence and a calibration exercise reveal that the subsidy has a sizable impact on the availability of credit. The third paper assesses the role of policy uncertainty in the Great Recession. The Great Recession features substantial geographic variation in employment losses, a fact that is often presented as a challenge to uncertainty-based models of the downturn. In this paper we show that there is a substantial correlation between the distribution of employment losses and the increases in local measures of both economic and policy uncertainty. This relationship is robust across a wide range of measures.