Working Paper: NBER ID: w13260
Authors: Bruce Preston; Mauro Roca
Abstract: This paper solves a real business cycle model with heterogeneous agents and uninsurable income risk using perturbation methods. A second order accurate characterization of agent's optimal decision rules is given, which renders the implications of aggregation for macroeconomic dynamics transparent. The role of cross-sectional holdings of capital in determining equilibrium dynamics can be directly assessed. Analysis discloses that an individual's optimal saving decisions are almost linear in their own capital stock giving rise to permanent income consumption behavior. This provides an explanation for the approximate aggregation properties of this model documented by Krusell and Smith (1998): the distribution of capital does not affect aggregate dynamics. While the variance-covariance properties of endogenous variables are almost entirely determined by first order dynamics, the second order dynamics, which capture properties of the wealth distribution, are nonetheless important for an individual's mean consumption and saving decisions and therefore the mean equilibrium capital stock. Policy evaluation exercises therefore need to take account of these higher order terms.
Keywords: Heterogeneous agents; Incomplete markets; Macroeconomic dynamics; Real business cycle model
JEL Codes: C6; D52; E21; E32
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| individual capital stock (E22) | individuals' optimal saving decisions (D14) |
| individuals' optimal saving decisions (D14) | permanent income consumption behavior (D15) |
| first-order dynamics (C69) | variance-covariance properties of endogenous variables (C51) |
| second-order dynamics (C69) | mean consumption and savings decisions (E21) |
| incomplete markets and heterogeneity (D52) | macroeconomic outcomes (E66) |