The New Keynesian Transmission Mechanism: A Heterogeneous-Agent Perspective

This paper studies how the simplest possible form of household heterogeneity – splitting the representative agent of the textbook New Keynesian model into a “worker,” who receives only labor income, and a “capitalist,” who receives only firm profits – changes the model’s monetary transmission mechanism. Under the standard assumption that only goods prices are sticky and wages are flexible, the authors show that this 2-agent model behaves very differently from its representative-agent counterpart: the real interest rate, inflation, real wages, and profits all respond similarly to a monetary policy shock, but output and employment do not respond at all in the worker-capitalist model, whereas they fall sharply in the standard model. The reason is that with the balanced-growth (King-Plosser-Rebelo) preferences standard in macroeconomics, income and substitution effects on labor supply exactly cancel; once profit income is removed from a worker’s budget (because a worker earns only wages), this cancellation makes hours completely unresponsive to wage movements, so monetary policy only redistributes consumption between workers and capitalists – it does not move aggregate output. The authors then show that the representative-agent model’s own ability to generate an output response rests on an empirically fragile mechanism: profits move countercyclically with the policy rate, making the representative household poorer and inducing it, via a wealth effect, to work more – a channel undermined both by household balance-sheet data showing few households hold much non-labor income, and by the fact that profits are procyclical, not countercyclical, in the data. When wage stickiness is introduced instead of (or alongside) price stickiness, however, workers are pushed off their static labor-supply curve and simply supply whatever hours are demanded; in this case the worker-capitalist model’s impulse responses become nearly indistinguishable from the representative-agent model’s, and the authors show this equivalence strengthens as the degree of wage rigidity increases. The authors confirm these results are robust to allowing limited financial trade between workers and capitalists via a bond market with adjustment costs.

Erik Öberg | Macro Paper Warehouse

The New Keynesian Transmission Mechanism: A Heterogeneous-Agent Perspective