Why Does Unemployment Risk Reduce the MPC over the Business Cycle?

Abstract

Using survey evidence and revisiting the 2008 tax rebate, I document that unemployment risk significantly reduces the marginal propensity to consume (MPC), to an extent that standard buffer-stock models cannot replicate. In buffer-stock models, while the stronger precautionary saving motive raises the MPC, the effectively less binding borrowing constraint lowers it, resulting in only a modest net effect. I introduce mental accounting to the model to resolve this limitation through a behavioral switching mechanism, while simultaneously aligning the model with other stylized facts on the MPC. Embedding this model into a general equilibrium framework reveals strikingly different MPC dynamics in recessions. In the mental accounting model, the MPC drops immediately and remains low throughout the recession, whereas in the standard model, it only gradually declines as households build up savings. Consequently, stimulus checks are 30% less effective in increasing aggregate consumption during recessions than predicted by the standard model. This state-dependence of the MPC reconciles recent estimates of the modest aggregate effects of the 2008 tax rebate with the high MPCs documented in the literature.