However, somewhat surprisingly, very little attention has been paid thus far to the influence of labour market institutions on idiosyncratic unemployment risk faced by heterogeneous workers and the associated precautionary motives that drive their individual choices. As these motives are crucial determinants of household consumption and savings decisions, one can expect that they are also important for fluctuations in aggregate demand and, in the presence of price rigidities, in aggregate output. It can be argued that this gap in literature resulted mainly from the inability to analyse the business cycle evolution of consumer heterogeneity using standard macroeconomic setups and, in particular, dynamic stochastic general equilibrium (DSGE) models. These models, which can be currently considered a workhorse of macroeconomic research, rely on the assumption of complete financial markets, allowing one to insure against individual risk.
As a result, heterogeneity in labour market status (employment vs unemployment) does not necessarily translate into heterogeneity in spending, which facilitates aggregation and essentially allows one to rely on a representative agent framework. However, recent research clearly shows that heterogeneity between households and time-variation in inequality have important aggregate consequences. At the same time, recent advances in computational and numerical methods have allowed economists to relax the assumption on complete financial markets. This opens the door to rigorous investigation of how the precautionary motives of households facing unemployment risk interact with labour market institutions. In particular, our goal is to analyse the influence of labour market institutions on aggregate demand, which works as follows: shifts in the design of these institutions affect labour supply and demand, thus leading to changes in job-finding and separation rates that shape uninsured unemployment risk at an individual level. This, in turn, influences precautionary motives and, consequently, affects aggregate demand and output.
By making use of a selection of newly developed computational methods, our project is aimed at incorporating this intuitive channel into a dynamic business cycle model and to revisit the role of labour market institutions in macroeconomic stabilisation and aggregate demand management. If the mechanism that links the institutions with precautionary motives is sufficiently strong, which is in line with our research hypotheses, the project may then overturn the results of several canonical studies on labour market institutions that have ignored consumer heterogeneity and unemployment risk, or at least change their quantitative implications. In other words, by taking into account the interplay between these institutions and the aggregate demand effects of household heterogeneity, our goal is to shed new light on the optimal design of public intervention in the labour market.