The income of a household varies substantially over time and the uncertainty households face with respect to future incomes is large. This leads household to accumulate precautionary savings. In the past, most standard business cycle models, in particular models of monetary and fiscal policy have disregarded this point.
Our ERC project has contributed to the burgeoning literature that includes market incompleteness into the workhorse model of stabilization policy, the New Keynesian business cycle model. Introducing market incompleteness changes the way stabilization policy works, alters its welfare consequences and gives room to uncertainty and redistribution policies immediately affecting the business cycle.
Publications & Working Papers
Happiness and the Persistence of Income Shocks
We reassess the empirical effects of income and employment on self-reported well-being. Our analysis makes use of a two-step estimation procedure that allows us to apply instrumental variable regressions with ordinal observable data. As suggested by the theory of incomplete markets, we differentiate between the effects of persistent and transitory income shocks. In line with this theory, we find that persistent shocks have a significant impact on happiness while transitory shocks do not. This also has consequences for inference about the happiness effect of employment. We find that employment per se is associated with a decline in happiness.
Precautionary Savings, Illiquid Assets, and the Aggregate Consequences of Shocks to Household Income Risk
U.S. households face large income uncertainty that varies substantially over the business cycle. We examine the macroeconomic consequences of these variations in a model with incomplete markets, liquid and illiquid assets, and a nominal rigidity. Heightened uncertainty depresses aggregate demand as households respond by hoarding liquid “paper” assets for precautionary motives, thereby reducing both illiquid physical investment and consumption demand. This translates into output losses, which the central bank can only prevent by providing sufficient liquidity. We show that the welfare consequences of uncertainty shocks crucially depend on a household’s asset position. Households with little human but high illiquid non-human wealth lose most from an uncertainty shock and gain most from stabilization policy.
Transmission of Monetary Policy with Heterogeneity in Household Portfolio
This paper assesses the importance of heterogeneity in household portfolios for the transmission of monetary policy in a New Keynesian business cycle model with incomplete markets and portfolio choice under liquidity constraints. In this model, the consumption response to changes in interest rates depends on the joint distribution of labor income, liquid and illiquid assets. The presence of liquidity-constrained households weakens the direct effect of changes in the real interest rate on consumption, but at the same time makes consumption more responsive to equilibrium changes in labor income. The redistributive consequences, including debt deflation, amplify the consumption response, whereas they dampen the investment response. Market incompleteness has important implications for the conduct of monetary policy as it relies to a larger extent on indirect equilibrium effects in comparison to economies with a representative household.
Public Insurance and Wealth Inequality – A Euro Area Analysis
I document that within the euro area those countries with lower inequality in household incomes after tax and transfers show a higher inequality in private net wealth. Going back to the argument by Hubbard, Skinner and Zeldes (1995) that public insurance crowds out private savings specially of the poor, I construct a life cycle model with heterogeneous households and incomplete markets that features labor market risk, income taxes, social transfers and public pensions. Calibrating the model to the actual benefit and tax systems, the model matches the negative correlation and wealth Gini coefficients for most countries very well. It is shown that cross-country correlation of wealth and disposable income inequality turns from positive to negative, if I successively add cross country-specific features of the benefit and tax system to a model with initially no government intervention, but only differences in income risks. Redistributive policies can account for 59.8% of the cross-country differences in the Gini coefficients for the bottom 95% of the wealth distribution. The model results suggest that asset mean-tested minimum-income support programs contribute with 39.3% to the wealth inequality differences across the euro area, while public pensions can rationalize about 17.2%.