Tobias Broer, Paris School of Economics

"Consumption insurance over the business cycle"

Abstract

In U.S. micro data, consumption smoothing is cyclical: consumption reacts more to idiosyncratic income changes in booms. This matters for average costs of business cycles and aggregate fluctuations in consumption demand. In standard models of self-insurance, where individuals borrow and save to smooth income fluctuations, consumption smoothing is strong when a temporarily low average wage level or low interest rates make current shocks less important for permanent income, and when high savings rates relax future borrowing constraints of low-wealth households. When studying these determinants in the general equilibrium of a standard business-cycle model with incomplete markets and idiosyncratic risk, procyclical wealth accumulation makes consumption smoothing substantially more effective in booms. To solve this "countercyclical consumption smoothing puzzle", we explore alternative market structures, income processes and misperception of idiosyncratic risk. Procyclical bias in the perceived persistence of idiosyncratic shocks can help solve the puzzle.

Contact person: Jeppe Druedahl