Alisdair McKay | Macro Paper Warehouse

A Tractable Income Process for Business Cycle Analysis

Thu, 01 Jan 2026 00:00:00 +0000

Guvenen, McKay, and Ryan estimate a stochastic income process for US male workers that simultaneously matches five empirical regularities from Social Security Administration administrative panel data covering 1978–2011: (i) flat and acyclical variance of income growth rates, (ii) volatile and procyclical Kelley skewness, (iii) very high kurtosis — targeted at 20 for one-year changes and 12 for five-year changes — (iv) a near-linear rise in cross-sectional log-income variance from age 25 to 55, and (v) a systematic factor structure in business cycle incidence whereby income losses during recessions are predictably related to a worker’s pre-recession income rank. All five facts are drawn from Guvenen et al. (2014) and Guvenen et al. (2021), which document them from SSA records on individual income histories.

Optimal Policy Rules in HANK

This paper characterizes optimal monetary and fiscal policy rules in a rich heterogeneous-agent New Keynesian (HANK) business-cycle model with nominal rigidities, in which the policymaker has two instruments – the short-term nominal interest rate and uniform lump-sum transfer (stimulus-check) payments – and asks whether, and how, household inequality should change how each instrument is set. For a policymaker with a conventional “dual mandate” that targets aggregate output and inflation, the paper proves the optimal interest-rate targeting rule is exactly the same as in the textbook representative-agent New Keynesian model, because in this economy household heterogeneity affects only the demand side, which is a slack constraint once the supply-side Phillips curve is left unchanged; empirically disciplined HANK and RANK models therefore prescribe essentially the same policy-rate paths. The paper then adds an explicit distributional objective – a planner who wants to insure households against business-cycle-driven swings in their consumption shares – and derives a linear-quadratic optimal rule with an additional term governed by the causal effect of each instrument on consumption inequality. Because the calibrated model, built to match evidence on monetary transmission, implies that interest-rate changes move household consumption by roughly similar percentages up and down the wealth and income distribution, this distributional term turns out to matter little in practice: optimal monetary policy stays close to the dual-mandate benchmark even when the planner cares about inequality, because using rates to fight inequality would require costly departures from aggregate stabilization for limited distributional gain. Stimulus checks, by contrast, have strongly progressive effects in the model – both from elevated marginal propensities to consume among low-income, low-wealth households and from a fixed dollar transfer mattering more as a share of low incomes – so they are shown to be an effective complementary tool for offsetting shocks with a strong distributional tilt, such as a simulated income-redistribution shock resembling the Covid-19 recession. These conclusions are explicitly conditional on the paper’s calibration of policy transmission channels; the authors show that alternative model specifications implying larger distributional effects of monetary policy (as in some other recent HANK papers) would restore a more significant role for distributional considerations in interest-rate policy.

The Power of Forward Guidance Revisited

This paper shows that the striking power of far-future forward guidance in standard New Keynesian models – a phenomenon the literature has dubbed the “forward guidance puzzle,” in which promised interest rate changes further in the future can have larger, even explosive, effects on current output and inflation than near-term changes – depends critically on the assumption of complete markets. The mechanism behind the puzzle is that the model’s consumption Euler equation, solved forward, implies current consumption responds to an undiscounted sum of expected future real-rate changes, so a household’s consumption jumps immediately and by the same amount whether a promised rate cut is one quarter or five years away. The authors argue this is unrealistic: households facing uninsurable idiosyncratic income risk and borrowing constraints will be reluctant to run down precautionary savings to fully exploit a distant promised rate cut, since doing so leaves them more exposed to future income shocks before the cut even arrives. Embedding this logic in a general equilibrium incomplete-markets New Keynesian model, the paper finds that the effect of forward guidance falls monotonically with horizon – about 40 percent of the complete-markets effect for guidance five years out, and essentially zero at ten years – with the degree of “discounting” increasing in the amount of idiosyncratic risk households face and decreasing in the level of assets available for self-insurance. The same mechanism substantially weakens forward guidance as a tool for escaping a zero-lower-bound recession: an extension of near-zero rates that would fully eliminate a simulated Great-Recession-sized downturn under complete markets leaves a substantial recession and much larger deflation under incomplete markets.

The Role of Automatic Stabilizers in the U.S. Business Cycle

This paper builds a quantitative business-cycle model that “merges the standard incomplete-markets model of consumption and inequality with the new Keynesian model of nominal rigidities and business cycles,” calibrated to U.S. tax-and-transfer data, in order to directly measure whether automatic fiscal stabilizers actually reduce the volatility of aggregate activity – rather than merely measuring, as most prior work did, how strongly taxes and transfers co-move with income. The authors define a “stabilization coefficient” as the proportional change in the ergodic variance of an aggregate when a given stabilizer is switched off, and use it to evaluate four theoretical channels: the conventional disposable-income channel, a marginal-incentives channel, a redistribution channel, and a social-insurance channel. They find that “the conventional argument that stabilizing disposable income will stabilize aggregate demand plays a negligible role in the dynamics of the business cycle,” since U.S. marginal tax rates barely change between booms and recessions, whereas “tax-and-transfer programs that affect inequality and social insurance can have a larger effect on aggregate volatility” – unemployment benefits and safety-net transfers meaningfully reduce output and hours volatility by redistributing toward households whose spending and labor-supply choices respond strongly, and by reducing the precautionary saving that idiosyncratic unemployment risk induces. Even so, “as currently designed, the set of stabilizers in place in the U.S. has had little effect on the volatility of aggregate output fluctuations,” largely because monetary policy under a near-optimal rule already does most of the stabilization work, leaving little residual role for fiscal channels; the automatic stabilizers become considerably more important when monetary policy is far from optimal or constrained, as at the zero lower bound. Finally, while removing the stabilizers would substantially lower utilitarian welfare, the paper shows this loss is due almost entirely to the redistribution and social insurance the stabilizers provide, not to any change in the amplitude of the business cycle itself.