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

Abstract

Previous research has studied how unemployment risk affects consumption dynamics, but little is known about its effect on the marginal propensity to consume (MPC), which is crucial for the analysis of fiscal stimulus during recessions. Using survey data, I document that unemployment risk significantly reduces the MPC, to an extent that standard buffer-stock models cannot replicate. To reconcile with the data, I introduce mental accounting to the model, where households treat income and savings as non-fungible and exhibit dissaving aversion. Mental accounting generally increases the MPC, but endogenously becomes less salient when unemployment risks heighten, effectively reducing the MPC. A quantitative HANK model with mental accounting reveals that stimulus checks are 30% less effective in stimulating aggregate consumption during recessions than predicted by the standard model. This state dependence of the MPC reconciles the modest aggregate effects of the 2008 tax rebate with the high MPCs documented in the empirical literature.