RWP 20-13, September 2020; updated October 2021
This paper investigates how, and how much, household financial distress (FD), arising from allowing debts to go unpaid, matters for the aggregate and cross-sectional consumption responses to macroeconomic risk. Through a battery of structural models, we show that FD can affect consumption responses through three channels: (1) as another margin of adjustment to shocks (direct channel); (2) because its persistence implies a significant degree of preference heterogeneity (indirect channel); and (3) because it can exacerbate macroeconomic risks whenever it is more severe in the hardest-hit regions, as evinced by the last two recessions (correlation channel). We find that all channels shape cross-sectional differences in the response of consumption to shocks. However, only the direct and indirect channels matter in the aggregate.
JEL Classification: D31, D58, E21, E44, G11, G12, G21
Athreya, Kartik, Ryan Mather, José Mustre-del-Río, and Juan M. Sánchez. 2020. “Financial Distress and Macroeconomic Risks.” Federal Reserve Bank of Kansas City, Research Working Paper no. 20-13, September. Available at External Linkhttps://doi.org/10.18651/RWP2020-13
Note: A previous version of this RWP from September 2020 was titled "Household Financial Distress and the Burden of "Aggregate" Shocks"