Aggregate Consumption in Times of Crisis: The Role of Financial Frictions

The joint behaviour of US aggregate consumption and saving over the period 2007–2009,and notably the pronouned U-shaped pattern of consumption together with the risein saving, are difficult to reconcile with the view that financial markets are frictionless.We propose an alternative framework in which financial markets are incomplete andwhere households form a buffer stock of precautionary saving to self-insure against the(time-varying) risk of falling into unemployment, with the consequence of considerablyamplifying and propagating crises. Our model can be solved in closed form because thewealth heterogeneity generated by uninsured income shocks remains minimal. We end thearticle by arguing that fully incorporating uninsured and time-varying individual risks intomacroeconomic analysis may drastically alter our understanding of the business cycle,macroeconomic policy, and the role of financial intermediaries