Inequality, Risk, and Business Cycles

Abstract

We quantify the connection between inequality, risk, and business cycles in a medium-scale New Keynesian model with tractable household heterogeneity, estimated with aggregate and cross-sectional data. We find that inequality and risk substantially amplify cyclical fluctuations. Most of this amplification operates through cyclical precautionary saving induced by countercyclical idiosyncratic risk. Savers reduce their consumption to insure themselves against large income drops, whose likelihood rises in recessions. Independent evidence supports both the magnitude and broad incidence of this recessionary increase in risk across skill and income groups, and indicates that the sizable, countercyclical premium on illiquid claims generated by the same mechanism is quantitatively plausible.