Cyclical labor income risk and consumption dynamics in large recessions

Abstract

Recent empirical studies on labor income dynamics depict recessions as times when employed households face a higher risk of large and long-lasting income declines. Motivated by this evidence, we build a real business cycle model with heterogeneous agents and incomplete markets, in which aggregate productivity fluctuates, and idiosyncratic labor income risk varies along the business cycle. We use the model to investigate how much higher labor income risk during the Great Recession can account for the observed sharp and prolonged drop in US aggregate consumption. Compared to a model with just unemployment risk, we find that including cyclical labor earning risk amplifies the initial response of aggregate consumption to severe recessions by one percentage point (from 2% to 3%), and its subsequent recovery is significantly weakened. Also, we corroborate that the result holds even if TFP remains constant. However, we argue that TFP fluctuations should be considered, as we show that they contribute substantially to the sharp drop in consumption and its sluggish recovery.