By Heejeong Kim
What drives sharp declines in aggregate quantities over the Great Recession? I study this question by building a dynamic stochastic overlapping generations economy where households hold both low-return liquid and high-return illiquid assets. In this environment, I consider shocks to aggregate TFP that occur alongside a rise in risk of a further economic downturn. Importantly, a higher probability of an economic disaster is consistent with the recent evidence finding a decline in households’ expected income growth over the Great Recession. I also show that a rise in disaster risk explains the rise in savings rates, seen in the micro data over the Great Recession. When calibrated to reproduce the distribution of wealth as well as the frequency and severity of disasters reported in Barro (2006), a rise in disaster risk, and an empirically consistent fall in TFP, explains around 70 percent of the decline in aggregate consumption and more than 50 percent of the decline in investment over the Great Recession. Comparing my model to an economy without illiquid assets, I find that household variation in the liquidity of wealth plays a key role in amplifying the effect of a rise in disaster risk.
I am not sure the risk of disaster increased, rather it is the subjective probability of a disaster that increased. When the Great Recession hit, very few in that generation had experienced a deep recession. An economic disaster was simply not on the radar, despite the gold nuts’ best efforts. Just like now it is unfathomable to have interest rates that are close to zero. Economics memories are surprisingly short. In any case, these kind of changes, whether they are subjective or not, matter, as this paper shows.