Endogenous Job Destruction Risk and Aggregate Demand Shortages

Abstract

This paper studies, analytically and quantitatively, the occurrence of demand-deficient recessions due to uninsurable unemployment risk when jobs are endogenously destroyed. The ensuing unemployment fears induce a precautionary saving motive that counteracts the desire to borrow during recessions: negative productivity shocks may cause falling natural interest rates and positive unemployment gaps. Analytically, these demand-deficient recessions are shown to require a lesser degree of real wage rigidity when jobs are destroyed endogenously rather than exogenously. Quantitatively, the demand-deficient nature of supply-driven recessions can only be captured when accounting for endogenous job destruction.

Keywords: Heterogeneous Agents, Unemployment Risk, Endogenous Separation, Keynesian Supply Shocks