Location: 368A Heady Hall

Description: Aubhik Khan
"Large recessions in an overlapping generations model with unemployment risk."

Abstract: I explore business cycles in quantitative overlapping generations economies where households face earnings risk characterised by the high kurtosis seen in the data, and unemployment risk. To evaluate the role of uninsurable risk and precautionary savings in explaining the large fall in consumption seen in the recent recession, I introduce preferences that allow for high levels of risk aversion alongside a relatively high elasticity of intertemporal substitution. When aggregate fluctuations are driven by persistent shocks to TFP growth, and the price of capital is procyclical, households’ preferences imply a high price of risk and countercyclical stochastic discount factors.

The model economy exhibits large inter-generational differences in wealth driven by households’ savings over the life-cycle. This substantially increases the inequality of wealth arising from households’ response to uninsurable income risk, and reproduces much of the wealth inequality in the data.
 
Solving for equilibrium under aggregate uncertainty, I explore the mechanics of a large recession, driven by a persistent shock to TFP growth, for both aggregate consumption and investment and the distribution of households. While TFP fell relatively little, in the recent recession, there was a large fall in hours worked. Consistency with these observations, in the model, requires a large, persistent increase in unemployment risk. The presence of large uninsurable risk drives a large fall in aggregate consumption, in the model, when a persistent fall in TFP growth, as seen in the Great Recession, is accompanied by a rise in unemployment risk. In contrast, investment falls by more when households face little income risk, holds less precautionary savings, and are more responsive to changes in real interest rates.

Importantly, our incomplete markets model generates declines in aggregate quantities similar to that seen in the Great Recession. As a result, it allows us to evaluate the welfare costs of a large recession in an incomplete markets model consistent with the overall aggregate business cycle. Overall, the welfare costs of the recession vary by the share of income households derive from capital and labour. Younger workers, with relatively low levels of wealth, suffer most of the large fall in expected earnings. These welfare costs are large, given the persistence of the recession and its large impact on the earnings of finite-lived households.

Contact Person: Juan Carlos cordoba