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Engineering a Paradox of Thrift Recession

Zhen Huo and José-Víctor Ríos-Rull
CQER Working Paper 13-03
April 2013

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We build a variation of the neoclassical growth model in which financial shocks to households or wealth shocks (in the sense of wealth destruction) generate recessions. Two standard ingredients that are necessary are (1) the existence of adjustment costs that make the expansion of the tradable goods sector difficult and (2) the existence of some frictions in the labor market that prevent enormous reductions in real wages (Nash bargaining in Mortensen-Pissarides labor markets is enough). We pose a new ingredient that greatly magnifies the recession: a reduction in consumption expenditures reduces measured productivity, while technology is unchanged due to reduced utilization of production capacity. Our model provides a novel, quantitative theory of the current recessions in southern Europe.

JEL classification: E20, E32, F44

Key words: Great Recession, paradox of thrift, endogenous productivity


José-Víctor Ríos-Rull thanks the National Science Foundation for Grant SES-1156228. The authors are thankful for discussions with Yan Bai, Kjetil Storesletten, and Nir Jaimovich and the comments of Joan Gieseke and of the attendees at the many seminars where this paper was presented. The views expressed herein are those of the authors and not necessarily those of the Federal Reserve Banks of Atlanta or Minneapolis or the Federal Reserve System. Any remaining errors are the authors' responsibility.

Please address questions regarding content to Zhen Huo, University of Minnesota and Federal Reserve Bank of Minneapolis, Economic Research, 90 Hennepin Avenue, Minneapolis, Minnesota 55401, huoxx016@umn.edu or José-Víctor Ríos-Rull, University of Minnesota, Federal Reserve Bank of Minneapolis, CAERP, CEPR, and NBER, Department of Economics, 4-101 Hanson Hall, office 4-179, 1925 Fourth Street South, Minneapolis, Minnesota 55455, vr0j @ umn.edu

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