Household Volatility, Household Debt and the Great Moderation

WORK IN PROGRESS. VERY PRELIMINARY. Between 1952 and 1982, the cyclical correlation between household mortgage debt and aggregate economic activity was around 0.80; in the last 25 years, this correlation has been almost zero. During the same period, the volatility of residential investment has sharply fallen, accounting for a large fraction of the Great Moderation. In this paper, we provide an explanation for these facts. We argue that a common factor can explain at the same time the declining cyclicality of household debt and the reduced volatility of household investment. This factor is the larger household income volatility of the last decades: larger income volatility at the individual level makes individual more cautious about changing their stock of durables, thus making purchases of durable goods less sensitive to given size aggregate shocks. We formalize these points using a calibrated version of the stochastic growth model with housing investment, collateralized household debt and uninsurable idiosyncratic and aggregate shocks. We distin-guish between an early period (1950s through 1970s), when individual risk was relatively small, aggregate risk was relatively high, and maximum loan-to-value ratios were low; and a late period (1980s throug