What Explains High Unemployment? The Aggregate Demand Channel

Abstract:     
A drop in aggregate demand driven by shocks to household balance sheets is responsible for a large fraction of the decline in U.S. employment from 2007 to 2009. The aggregate demand hypothesis for employment losses makes the joint prediction that job losses in the non-tradable sector will be higher in high leverage U.S. counties that were most severely impacted by the balance sheet shock, while losses in the tradable sector will be distributed uniformly across all counties. We find exactly this pattern from 2007 to 2009. Alternative hypotheses for job losses based on business uncertainty or structural unemployment related to construction do not explain our results. Using the relation between non-tradable sector job losses and demand shocks and assuming Cobb-Douglas preferences over tradable and non-tradable goods, we quantify the effect of aggregate demand channel on total employment. Our estimates suggest that the decline in aggregate demand driven by household balance sheet shocks accounts for almost 4 million of the lost jobs from 2007 to 2009, or 65% of the lost jobs in our data.

Number of Pages in PDF File: 49

Keywords: Great Recession, Unemployment, Aggregate Demand

JEL Classification: E20, E30, E40, E51

working papers series