Firm Debt Deflation, Household Precautionary Savings, and the Amplification of Aggregate Shocks
Abstract
Deleveraging shocks that increase household precautionary savings, and financial and uncertainty shocks to firms, interact and amplify each other, even when these same shocks separately have moderate effects on output and employment. This result is obtained in a model in which heterogeneous households face financial frictions and unemployment risk and in which heterogeneous firms borrow funds using nominally fixed long-term debt and face costly bankruptcy. This novel amplification mechanism is based on a dynamic feedback between the precautionary behavior of households and the bankruptcy and entry decisions of firms. Our results support the view that firm financial frictions are important to understand the effect of household deleveraging on unemployment, consistent with recent empirical studies examining the 2007-2009 Great Recession.
