Does Unemployment Risk Affect Business Cycle Dynamics?

Abstract

In this paper, I show that the decline in household consumption during unemployment spells depends on both liquid and illiquid asset positions. I also provide evidence that unemployment spells predict the withdrawal of illiquid assets, particularly when households have few liquid assets. Motivated by these findings, I embed endogenous unemployment risk in a two-asset heterogeneous-agent New Keynesian model. The model is consistent with the above evidence and provides a new propagation mechanism for aggregate shocks due to a flight-to-liquidity that occurs when unemployment risk rises. This mechanism implies that unemployment insurance plays an important role as an automatic stabilizer, particularly when monetary policy is constrained.

Keywords: Heterogeneous-agent model, liquid and illiquid assets, Unemployment insurance, Unemployment risk

JEL Classification: E10, E24, E32, E62, J64