Wealth And High Business Cycle Volatility
Jonathan Heathcote
Federal Reserve Bank of Minneapolis and CEPR
Fabrizio Perri
Federal Reserve Bank of Minneapolis, NBER, and CEPR
Abstract
Periods of low household wealth in United States macroeconomic history have also been periods of high business cycle volatility. This paper develops a simple model that can exhibit self-fulfilling fluctuations in the expected path for unemployment. The novel feature is that the scope for sunspot-driven volatility depends on the level of household wealth. When wealth is high, consumer demand is largely insensitive to unemployment expectations and the economy is robust to confidence crises. When wealth is low, a stronger precautionary motive makes demand more sensitive to unemployment expectations, and the economy becomes vulnerable to confidence-driven fluctuations. In this case, there is a potential role for public policies to stabilize demand. Microeconomic evidence is consistent with the key model mechanism: during the Great Recession, consumers with relatively low wealth, ceteris paribus, cut expenditures more sharply.
Wealth And High Business Cycle Volatility – Introduction
Over the past 10 years a large fraction of U.S. households experienced a large and persistent decline in net worth. Figure 1 plots median real net worth from the Survey of Consumer Finances (SCF), for the period 1989-2013, for households with heads between ages 22 and 60. Since 2007 median net worth for this group has roughly halved and shows no sign of recovery through 2013. In relation to income, the decline is equally dramatic: the median value for the net worth to income ratio fell from 1.58 in 2007 to 0.92 in 2013.
The objective of this paper is to study the business cycle implications of such a large and widespread fall in wealth. We will argue that falls in household wealth (driven by falls in asset prices) leave the economy more susceptible to confidence shocks that can increase macroeconomic volatility. Figures 2 and 3 provide some motivating evidence for our claim.
Figure 2 shows a series for the log of total real household net worth in the United States from 1920 to 2013, together with its linear trend. The figure shows that over this period there have been three large and persistent declines in household net worth: one in the early 1930s, one in the early 1970s, and the one that started in 2007. All three declines have marked the start of periods characterized by deep recessions and elevated macroeconomic volatility.
Figure 3 focuses on the postwar period, for which we can obtain a consistent measure of macroeconomic volatility. We measure volatility as the standard deviation of quarterly real GDP growth rate over a 10-year window. The figure plots this measure of volatility for overlapping windows starting in 1947.1 (the values on the x-axis correspond to the end of the window), together with wealth, measured as the average deviation from trend (the difference between the blue and red lines in Figure 2) over the same 10-year window. The figure reveals that periods when wealth is high relative to trend, reflecting high prices for housing or stocks (or both), tend to be periods of low volatility in aggregate output (and hence employment and consumption). Conversely, periods in which net worth is below trend tend to be periods of high macroeconomic volatility. For example, during windows ending in the late 1950s and early 1980s, wealth is well below trend and volatility peaks; conversely, in windows ending in the early 2000s, wealth is well above trend and volatility is low.
Why should wealth affect volatility? We develop a micro-founded dynamic equilibrium model in which economic fluctuations are driven by fluctuations in household optimism or pessimism. The novel feature is that the scope for equilibrium fluctuations due to animal spirits” depends crucially on the value of wealth in the economy, which is in turn determined by fundamentals. When the fundamentals are such that wealth is high, the economy has a unique equilibrium and is not subject to confidence-driven fluctuations. When wealth is low, there are multiple possible equilibria, and the economy is vulnerable to confidence-driven fluctuations that are a source of macroeconomic volatility. In this case, there is a potential role for public policies to stabilize demand.
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