Incomplete Markets, Heterogeneity and Macroeconomic Dynamics

Bruce Preston and Mauro Roca

No 13260, NBER Working Papers from National Bureau of Economic Research, Inc

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.

JEL-codes: C6 D52 E21 E32 (search for similar items in EconPapers)
Date: 2007-07
New Economics Papers: this item is included in nep-bec, nep-cba, nep-dge and nep-mac
Note: EFG
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Citations: View citations in EconPapers (59)

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