Labor earning shocks exhibit pro-cyclical skewness. We investigate how these cyclical risks account for the U.S. Great Recession’s consumption dynamics and assess to what extent welfare losses could be exacerbated. By building a model of incomplete markets with idiosyncratic unemployment and efficiency risk correlated with aggregate shocks, we find three main differences compared to a model with only cyclical unemployment. First, consumption’s initial decline is 0.5 percentage points larger, and its recovery is significantly slower. Second, aggregate welfare losses are more prominent in terms of lifetime consumption: 4.1% versus 3.1%. Third, the cross-sectional distribution of welfare losses has a thicker and longer right tail, meaning a non-negligible fraction of households suffer major losses.
