Household Debt, Unemployment, and Slow Recoveries∗

This paper analyzes the effect of endogenous unemployment risk on the dynamics of recovery from a liquidity trap. In a liquidity trap, an adverse demand shock raises unemployment and produces a period of slow hiring. Slow hiring further reduces demand, both for standard precautionary reasons and because credit conditions endogenously worsen, reducing households’ ability to borrow and consume. The magnitude of this amplification depends on the persistence of the initial shock. Following a permanent shock that requires a period of deleveraging, initial employment falls 3.4 times more than in a complete markets benchmark. In addition, unemployment risk slows the pace of deleveraging because high unemployment tends to increase the dispersion of household debt holdings. I decompose the aggregate Euler equation into terms capturing the effect of binding borrowing constraints (deleveraging), and idiosyncratic consumption volatility (precautionary). I find that amplification occurs primarily due to higher precautionary saving by unconstrained households. Multiple equilibrium paths exist, and which one the economy follows depends on household expectations and the policy rule adopted by the central bank after the economy exits the trap. I find that forward guidance can be very powerful, because endogenous unemployment risk increases the responsiveness of aggregate consumption to future economic conditions. JEL Classification: E21, E44, E32, E24.