Working Paper: NBER ID: w24971
Authors: Pascal Michaillat; Emmanuel Saez
Abstract: At the zero lower bound, the New Keynesian model predicts that output and inflation collapse to implausibly low levels, and that government spending and forward guidance have implausibly large effects. 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 status. Since people partly save 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 zero-lower-bound equilibrium transforms from a saddle to a source—which resolves all the anomalies.
Keywords: New Keynesian Model; Wealth in Utility; Zero Lower Bound; Government Spending; Forward Guidance
JEL Codes: E31; E32; E43; E52; E71
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Wealth in utility function (D11) | Euler equation modification (C69) |
| Euler equation modification (C69) | Consumption response to interest rates (E21) |
| Wealth in utility function (D11) | Consumption response to interest rates (E21) |
| High marginal utility of wealth (D11) | Euler-Phillips system transitions from saddle to source (C69) |
| Euler-Phillips system transitions from saddle to source (C69) | Prevents output collapse (D57) |
| Euler-Phillips system transitions from saddle to source (C69) | Prevents inflation collapse (E31) |