Over the past two decades, the U.S. economy has experienced several major crises that have influenced the behaviour of households, firms, and economic authorities. As a matter of fact, events such as the recent financial meltdown, the terrorist attacks in 2001, the Russian crisis in 1998, and the Gulf war of 1990 have been followed by a period of high uncertainty, which is why we will refer to these as uncertainty shocks.
Following these shocks, the decisions made by economic agents, be it firms or households, can differ substantially according to the state of the economy. For instance, if we focus on households’ consumption growth, we see that aggregate consumption growth of non-durable goods shows high volatility during the months immediately following the events of 1990 and 2001, but it shows relatively low volatility after the events of 1998 and 2007 (see Figures 2, 3 , 4, and 1).
Negative aggregate consumption growth has been observed on several occasions over the past decades, such as during the first Gulf war. The main difference in the recent pattern of consumption growth with respect to the past events is that low or negative growth rates have persisted over several quarters. Uncertainty shocks that are preceded by a period of high volatility states (B and D, in Figure 1) are characterized by negative consumption growth. On the other hand, events that are preceded by low volatility states (A and C, in Figure 1) do not exhibit negative consumption growth immediately following an uncertainty shock. However, over the recent years, personal consumption expenditure growth fell to worse negative values than those observed in the early 1990’s.
In the present paper, I will investigate two key features of the economy that can determine the dynamics of aggregate consumption. One key feature is the role played by the microstructure of the production side. It is indeed very common in the New Keynesian literature to define nominal and real rigidities at firm-level and then to aggregate the whole sector. However, empirical studies show that the behaviour of individual firms can differ significantly from the behaviour of the aggregate production sector. The other factor that drives the dynamics of aggregate consumption is the risk pooling of the households. The way households insure against volatility in their earnings depends, of course, on their access to financial instruments to smooth out consumption.
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How does firm-level volatility affect aggregate dynamics?
