Idiosyncratic Income Risk and Aggregate Fluctuations

Abstract

We study the role of idiosyncratic income shocks for aggregate fluctuations within a simple heterogeneous household framework with no binding borrowing constraints. We show that the presence of idiosyncratic income shocks affects the economy's response to an aggregate shock in a way that can be captured by a consumption weighted average of the changes in uncertainty generated by the 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 shocks on aggregate fluctuations is quantitatively small, since most of the changes in uncertainty are concentrated among poorer (low consumption) households.