Insurance Cyclicality

Abstract

This paper investigates how households smooth consumption against idiosyncratic wage shocks in recessions and expansions. Labour market uncertainty amplifies during recessions, captured through the cross-sectional dispersion of wages. I focus on the relative contribution of two insurance mechanisms, namely, adjustments in labour supply and assets. My identification strategy exploits variation in expenditures, hours worked and wages over the business cycle, and is applied to US household panel data. I document a new empirical fact -- the contribution of labour supply to consumption smoothing increases during labour market downturns. I further show that this effect is concentrated among households with low liquid wealth at the start of the year. To demonstrate the link between asset liquidity and insurance cyclicality, I develop an incomplete market life-cycle model with multiple asset-types (liquid and illiquid) and an aggregate state that affects wage dispersion. The model shows that shifts in portfolio composition towards liquid assets in high uncertainty periods can help rationalize the empirical observation.

Keywords: Business cycle, Consumption smoothing, Labour supply, Liquid assets and Permanent wage shocks

JEL Classification: D14, E21, J22, J31