Carolina Fugazza (Università di Torino)

“A Life-Cycle Model with Unemployment Traps”

abstract

The Great Recession has highlighted that long-term unemployment may become a trap with loss of human capital. This paper extends the life-cycle model allowing for a small risk of long-term unemployment with permanent effects on labour income. Such nonlinear income risk dampens both early consumption and early investment in risky assets, resulting in an optimal equity portfolio share relatively flat in age. The driver of such flattening in the life-cycle profile is the resolution of uncertainty, as the worker ages, concerning this personal disaster. Shifting to such flatter investment profile away from a simple “age rule” delivers mean welfare gains that are three times larger than in models with linear labour income shocks.