Precautionary Saving and Aggregate Demand

Xavier Ragot, Julien Matheron, Juan F Rubio-Ramirez and Edouard Challe

No 932, 2013 Meeting Papers from Society for Economic Dynamics

Abstract: This paper introduces incomplete insurance against idioyncratic labour income risk into an otherwise standard New Keynesian business cycle model with involuntary unemployment. Following an adverse monetary policy shock that lowers aggregate demand, job creation is discouraged and unemployment risk (as summarised by the job-loss rate) persistently rises. Imperfectly insured households rationally respond to the rise in indosyncratic income uncertainty by increasing precautionary saving, thereby cutting consumption and depleting aggregate demand even further; this in turn magnifies the initial labour market contraction, further raises unemployment risk, and so on. A calibrated version of the model suggests that the aggregate demand-precautionary saving feedback loop may significantly amplify the impact of aggregate shocks on unemployment, relative to the full-insurance case.

Date: 2013
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Related works:
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Working Paper: Precautionary Saving and Aggregate Demand (2017)
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