Uninsured Idiosyncratic Risk, Liquidity Constraints and Aggregate Fluctuations

Abstract

I study the role played by uninsured idiosyncratic risk and liquidity constraints in the propagation of aggregate ¯uctuations. To this purpose, I compare the aggregate ¯uctuations of two model economies that differ in their insurance technologies only. In one of these model economies liquidity constrained households vary their holdings of a nominally denominated asset in order to buffer an uninsured idiosyncratic shock to their individual production opportunities. In the other economy every idiosyncratic component of risk can be costlessly insured. I ®nd that the limited insurance technology implies ¯uctuations in output that are 20% larger, ¯uctuations in hours relative to output that are 9% larger, ¯uctuations in consumption relative to output that are 18% smaller, and a correlation of hours and productivity that is 15% smaller than those that obtain under the full insurance technology.