Incomplete Markets and Aggregate Demand

Iván Werning

No 932, 2016 Meeting Papers from Society for Economic Dynamics

Abstract: I study the relationship between aggregate consumption and interest rates when mar- kets are incomplete. I first provide a generalized Euler relation involving the real interest rate, current and future aggregate consumption under extreme illiquidity (no borrowing and no outside assets). This provides a tractable way of incorporating incomplete markets into macroeconomic models. When household income risk is acyclical I show that this relation coincides with that of a representative agent, al- though time-varying discount factors may potentially act as aggregate demand shocks. The same representation extends to the case with positive liquidity as long as liquidity relative to income is acyclical. A corollary of these ‘as if’ results is that forward guid- ance policies are as powerful as in representative agent models. Away from the ‘as if’ benchmark, I show that aggregate consumption becomes more sensitive to inter- est rates, especially future ones, when idiosyncratic income risk is countercyclical or when liquidity is procyclical. Finally, I also apply my analysis to a Real Business Cy- cle model, providing an exact analytical aggregation result that complements existing numerical findings.

Date: 2016
New Economics Papers: this item is included in nep-dge and nep-mac
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Citations: View citations in EconPapers (9)

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Related works:
Working Paper: Incomplete Markets and Aggregate Demand (2015)
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Persistent link: https://EconPapers.repec.org/RePEc:red:sed016:932

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