Household Inequality and the Consumption Response to Aggregate Real Shocks

The drop in output and consumption that occurred during the Great Recession has been large and prolonged. We also ask to what extent household inequality before and after the Great Recession interacted with the recession itself to generate such a large and persistent drop in consumption. To reach our goal, we first review two key papers, Krusell and Smith (1998) and Krueger, Mitman, and Perri (2016), and summarize what we understand from quantitative macro models with aggregate uncertainty about wealth inequality, borrowing-constrained households with heterogeneous marginal propensities to consume (MPC), and the response of aggregate consumption to an aggregate shock. It is important to stress that the fraction of households that are borrowing constrained is not just the fraction of low-wealth households, but also depends on their portfolio composition, exposure to earnings risk, and, potentially, on what nondiscretionary expenses they expect We thus need a better measure of borrowing-constrained households.