Unemployment: The Impact From Wealth And Volatility

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It turns out that people worrying about unemployment can actually lead to a recession

According to Jonathan Heathcote and Fabrizio Perri of the Federal Reserve Bank of Minneapolis, low wealth environments are ripe for recessions because people are saving and not spending as freely because they are worried about unemployment. This self-fulfilling dynamic comes true because “not spending”, of course, eventually leads to a recession.

It’s all about the perceived risk of unemployment

Heathcote and Perri note that during periods of low household wealth in the U.S., business cycle volatility has also been high. They create a simple model that highlights self-fulfilling fluctuations in the expected path for unemployment. They note: “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.”

On the other hand, when wealth is low, “a stronger precautionary motive makes demand more sensitive to unemployment expectations, and the economy becomes vulnerable to confidence-driven fluctuations.”

The authors also point out the potential role for public policies in order to stabilize demand. They highlight that real-world experience confirms the mechanism of their proposed model. “Microeconomic evidence is consistent with the key model mechanism: during the Great Recession, consumers with relatively low wealth, ceteris paribus, cut expenditures more sharply.”

Details on the study

The first point to keep in mind is that a majority of U.S. households has experienced a large and persistent decline in net worth over the last decade. Figure 1 highlights the median real net worth from the Survey of Consumer Finances from 1989-2013 with the head of the household between ages 22 and 60. Since 2007, the median net worth for this group has been cut in half and shows no sign of recovery as of 2014.


The decline is equally stark with income. Heathcote and Perri note the median value for the net worth to income ratio dropped from 1.58 in 2007 to 0.92 in 2013. They argue that these kind of major decreases in household wealth (caused by declines in asset prices) leave the U.S. economy “more susceptible to confidence shocks that can increase macroeconomic volatility.”

Figures 2 and 3 are used to substantiate their argument. Figure 2 illustrates a series for the log of total real household net worth in the U.S. from 1920 to 2013, and its linear trend. You can see that during this period there have been three large and persistent declines in household net worth: in the early 1930s, in the early 1970s, and the so-called Great Recession that began in late 2007. Moreover, all three downturns in household net worth were followed by periods of deep recessions and high levels of macroeconomic volatility


Figure 3 is an example focusing on the postwar period, and it represents a consistent measure of macroeconomic volatility. Heathcote and Perri explain that they measure volatility as the standard deviation of quarterly real GDP growth rate across a 10-year period. The figure characterizes 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 decade.

From the graph, you can see that periods when wealth is relatively high, meaning high prices for housing or equities or both, are generally periods of low volatility in aggregate output (and therefore also low employment and consumption). On the other hand, periods in which net worth is relatively low tend are typically  periods of high macroeconomic volatility. The authors note that during periods ending in the late 1950s and early 1980s, wealth is quite low and volatility peaks; but in windows ending in the early 2000s, wealth is relatively high and volatility is on the low side.

Future research

Heathcote and Perri suggest they could develop “a richer, more quantitative version of the model.” One possible improvement would be to introduce household heterogeneity in net worth to specify the implications for aggregate precautionary demand of the highly uneven distribution of net worth in the U.S..

In concluding they note: “A richer model of labor markets, in which desired labor supply plays a role in the long-run adjustment process, is another important direction for future research.”

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