News Shocks, Precautionary Saving and Frictional Labour Markets

Abstract This paper develops a theory of how TFP news shocks can impact the economy via a Keynesian supply channel. With frictional labour markets, bad TFP news reduces firms’ incentive to post vacancies, worsening households’ employment prospects. Households respond by accumulating liquid assets and cutting spending for precautionary reasons, triggering a recession that compounds the labour market downturn. This mechanism is outlined analytically and numerically in a heterogeneous agent New Keynesian model, with supporting local projection evidence. The combination of labour market frictions and precautionary saving is necessary to match the joint output and nominal interest rate dynamics observed empirically following a news shock. In contrast to previous theories, the transmission mechanism leaves room for policy to mitigate the shock’s contractionary effects.