The Economics of Financial Stress

Abstract

We study the psychological costs of financial constraints and their economic consequences. Using a representative survey of U.S. households, we document the prevalence of financial stress in U.S. households and a strong relationship between financial stress and measures of financial constraints. We incorporate financial stress into an otherwise standard dynamic model of consumption and labor supply. We emphasize two key results. First, both financial stress itself and naivete about financial stress are important components of a psychology-based theory of the poverty trap. Sophisticates, instead, save extra to escape high-stress states because they understand that doing so alleviates the economic consequences of financial stress. Second, the financial stress channel dampens or reverses the counterfactual large negative wealth effect on labor earnings because relieving stress frees up cognitive resources for productive work. Financial stress also has macroeconomic implications on wealth inequality and fiscal multipliers.

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