How big are the welfare losses from severe economic downturns, such as the US Great Recession? How are those losses distributed across the population? In this chapter we answer these questions using a canonical business cycle model featuring household income and wealth heterogeneity that matches micro data from the Panel Study of Income Dynamics (PSID). We document how these losses are distributed across households and how they are affected by social insurance policies.We find that the welfare cost of losing one's job in a severe recession ranges from 2% of lifetime consumption for the wealthiest households to 5% for low-wealth households. The cost increases to approximately 8% for low-wealth households if unemployment insurance benefits are cut from 50% to 10%. The fact that welfare losses fall with wealth, and that in our model (as in the data) a large fraction of households has very low wealth, implies that the impact of a severe recession, once aggregated across all households, is very significant (2.2% of lifetime consumption). We finally show that a more generous unemployment insurance system unequivocally helps low-wealth job losers, but hurts households that keep their job, even in a version of the model in which output is partly demand determined, and therefore unemployment insurance stabilizes aggregate demand and output.

INTRODUCTION

The objective of this paper is to quantify the distribution of welfare losses across households induced by a severe economic downturn of the magnitude of the US Great Recession. As a laboratory for our analysis, we use an augmented version of the canonical Krusell–Smith (1998) real business cycle model with household income and wealth heterogeneity, as presented in Krueger, Mitman, and Perri (2016). The model features business cycles driven by productivity shocks in an economy populated by agents that face different types of idiosyncratic income shocks and accumulate wealth in order to finance consumption during retirement and to self-insure against idiosyncratic income risk. In this framework, a recession affects households in several ways. First, in an economic downturn more households find themselves without a job, and a job loss reduces their lifetime income, consumption and welfare.