Idiosyncratic Income Risk and Aggregate Fluctuations

Abstract

We study the role of idiosyncratic income risk for aggregate fluctuations within a simple heterogeneous households framework. We show that the presence of idiosyncratic income shocks affects the economy’s response to an aggregate shock even in the absence of binding borrowing constraints and/or cyclical income risk. Their impact can be captured by a consumption-weighted average of the changes in consumption risk generated by an aggregate shock. We apply this framework to two example economies —an endowment economy and a New Keynesian economy— and show that under plausible calibrations the impact of idiosyncratic income risk on aggregate fluctuations is quantitatively small, since most of the changes in consumption risk are concentrated among poorer (low consumption) households.