Does Unemployment Risk Affect Business Cycle Dynamics?

In this paper, I show that the decline in consumption during unemployment depends on both liquid and illiquid wealth; that unemployment predicts illiquid asset withdrawal, primarily when households have few liquid assets; and that increased idiosyncratic unemployment risk leads to a rise in saving overall, but also to a decline in investment in illiquid assets. Motivated by these new findings, I embed endogenous unemployment risk in a two-asset, heterogeneous-agent New Keynesian model. The model is consistent with the new evidence and suggests that aggregate shocks are amplified by a flight-to-liquidity when unemployment risk rises, particularly when monetary policy is constrained. (JEL E12, E21, E24, E52, G51)