Large Recessions in an Overlapping Generations with Unemployment

We explore business cycles in quantitative overlapping generations economies where households face earnings risk characterised by the high kurtosis seen in the data, and unemployment risk. The model economy exhibits large inter-generational differences in wealth driven by households' savings over the life-cycle. This substantially increases the inequality of wealth arising from households' response to uninsurable income risk, and reproduces much of the wealth inequality in the data. Solving for equilibrium under aggregate uncertainty, we explore the mechanics of a large recession for both aggregate consumption and investment and the distribution of households. Importantly, our incomplete markets model generates declines in aggregate quantities similar to that seen in the Great Recession. As result, it allows us to evaluate the welfare costs of a large recession in an incomplete markets model consistent with the overall aggregate business cycle. While TFP fell relatively little, in the recent recession, there was a large fall in hours worked. Consistency with these observations, in the model, requires a large, persistent increase in unemployment risk. Overall, the welfare costs of the recession vary by the share of income households derive from capital and labour. Younger workers, with relatively low levels of wealth, suffer most of the large fall in expected earnings. These welfare costs are large, given the persistence of the recession and its large impact on the earnings of finite-lived households. Uninsurable risk and wealth inequality help shape the aggregate response of the economy. Investment falls by more when households face little income risk, holds less precautionary savings, and are more responsive to changes in real interest rates.