Imperfect Risk-Sharing and the Business Cycle
NBER Working Paper No. 26032
This paper studies the aggregate implications of imperfect risk-sharing implied by a class of New Keynesian models with idiosyncratic income risk and incomplete financial markets. The models in this class can be equivalently represented as an economy with a representative household that has state-dependent preferences. These preference “shocks” are functions of households’ consumption shares and relative wages in the original economy with heterogeneous agents, and they summarize all the information from the cross-section that is relevant for aggregate fluctuations. Our approach is to use this representation as a measurement device: we use the Consumption Expenditure Survey to measure the preference shocks, and feed them into the equivalent representative-agent economy to perform counterfactuals. We find that deviations from perfect risk-sharing were an important determinant of the behavior of aggregate demand during the US Great Recession.
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Document Object Identifier (DOI): 10.3386/w26032