Time-Varying Uncertainty and Durable Adjustment

Abstract: A large share of demand fluctuations over the business cycle are due to fluctuations in consumer spending on durable goods. Households adjust their durable holdings infrequently, and adjustment is even less likely when the economy is in a recession than when it is in an expansion. This thesis investigates whether countercyclical variation in income uncertainty can explain the procyclicality of durable adjustment. Higher income uncertainty in recessions may lead households to postpone durable adjustment until the next expansion. I present a simple model of durable adjustment and show that higher uncertainty leads to an overall decline in the frequency of adjustment. The effect of time-varying uncertainty on durable adjustment is quantified with an incomplete markets model. The results suggest that a more left-skewed distribution of income growth during recessions can account for a large part of the cyclicality in durable adjustment frequencies in PSID data. Countercyclical left-skewness also performs better at explaining stylized facts than alternative hypotheses although I find that aggregate income is an important determinant of durable adjustment.