2012) Wealth and Volatility

Between 2007 and 2013, U.S. households experienced a large and persistent decline in net worth. The objective of this paper is to study the business cycle implications of such a decline. We argue that low wealth opens the door to self-fulfilling fluctuations. If wealth-poor house-holds expect high unemployment, they have a strong precautionary incentive to cut spending. In an environment in which output is demand-driven, this makes the expectation of high un-employment a reality. We first document that poor U.S. households cut spending during the Great Recession much more sharply than richer households, consistent with a precautionary in-terpretation. We then develop a macroeconomic model featuring unemployment risk, and study the link between asset values and the volatility and persistence of precaution-driven fluctuations.