Working Paper: CEPR ID: DP13775
Authors: Pascal Michaillat; Emmanuel Saez
Abstract: The New Keynesian model makes several anomalous predictions at the zero lower bound: collapse of output and inflation, and implausibly large effects of forward guidance and government spending. To resolve these anomalies, we introduce wealth into the utility function. The justification is that wealth is a marker of social status, and people value social status. Since people save not only for future consumption but also to accrue social status, the Euler equation is modified. As a result, when the marginal utility of wealth is sufficiently large, the dynamical system representing the equilibrium at the zero lower bound becomes a source instead of a saddle—which resolves all the anomalies.
Keywords: New Keynesian model; zero lower bound; wealth; utility function; forward guidance; government spending
JEL Codes: E32; E52; E62
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| original New Keynesian model (E12) | output and inflation collapse (E31) |
| response of households' consumption to real interest rates is overly strong (D15) | instability in the model (C62) |
| introduction of wealth into the utility function (D11) | modification of the Euler equation (E19) |
| modification of the Euler equation (E19) | new dynamical system behaves as a source at the ZLB (E19) |
| new dynamical system behaves as a source at the ZLB (E19) | less pronounced response of consumption to interest rates (E21) |
| new dynamical system behaves as a source at the ZLB (E19) | prevents complete collapse of output and inflation (E31) |
| output and inflation are bounded below by the ZLB steady state (E31) | will never drop to zero or below (C29) |
| forward guidance and government spending (E62) | limited effects on output and inflation in the new model (E19) |