Saving on a Rainy Day, Borrowing for a Rainy Day

By Sule Alan, Thomas Crossley and Hamish Low

http://d.repec.org/n?u=RePEc:koc:wpaper:1212&r=dge

The aim of this paper is to understand what a recession means for individual consumers, and to model in a life-cycle framework how individuals respond to recessions. Our focus is on the sharp increase in savings rates that have been observed in the current and recent recessions. We show empirically that these saving spikes were short-lived and common to all working age groups. We then study life-cycle models in which recessions involve one or more of: (i) an aggregate permanent negative shock to individual income; (ii) an increase in the variance of idiosyncratic permanent shocks; (iii) a tightening of credit constraints; (iv) asset market crashes. In simulations and in the data we aggregate explicitly from individual behavior. We model credit tightening as a constraint on new borrowing and this generates an option value of borrowing in good times. We show that the rise in the aggregate savings ratio is driven by increases in uncertainty, rather than tighening of credit; temporary shocks to the supply of credit generate increases in saving only among younger agents.

I would add that this paper shows that the quick run-up in the aggregate savings rate at the start od the recession was a perfectly rational response, and not due to a sudden waking up from a spending frenzy.

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