Precautionary Saving and Aggregate Demand

Abstract

How do fluctuations in households’ precautionary wealth contribute to the propagation of aggregate shocks? In this paper, we attempt to answer this question by formulating and estimating a tractable structural macroeconometric model of the business cycle with nominal frictions, unemployment and incomplete insurance against unemployment risk. We argue that, under those frictions, time-variations in precautionary wealth have two conflicting effects on output volatility: a stabilizing “aggregate supply” effect working through the supply of capital and potential output; and a destabilizing “aggregate demand effect” working through aggregate consumption and the output gap. We quantify these forces via a maximum-likelihood estimation of the structural parameters of the model, using as observables both aggregate and cross-sectional information (such as the extent of consumption insurance and the distributions of wealth and consumption across households). We find the impact of demand shocks on aggregates to be signficantly altered by time-varying precautionary saving.