Giovanni L. Violante | Macro Paper Warehouse

Who bears the costs of inflation? Euro area households and the 2021-2023 shock

Mon, 01 Jan 2024 00:00:00 +0000

This paper measures the heterogeneous first-order welfare effects of the 2021-2023 inflation surge across households in the four largest euro area countries (Germany, France, Italy, Spain). Motivation: euro area headline HICP inflation peaked at 10.6% (year-on-year) in October 2022, driven mainly by energy and food prices following Russia’s invasion of Ukraine; cumulatively over 2021-23 the price index rose roughly 14% in France and Spain, 16% in Italy and 20% in Germany. The classic question—who wins and who loses from surprise inflation, and through which channels—is the focus.

Microeconomic Heterogeneity and Macroeconomic Shocks

This essay analyzes the role of household heterogeneity for how the macroeconomy responds to aggregate shocks. After reviewing how quantitative macroeconomics incorporated household heterogeneity and market incompleteness over roughly three decades – work that, the authors argue, has been mostly confined to inequality and redistribution questions rather than business cycles, partly because of computational complexity and partly because of a widespread but “inaccurate” reading of Krusell and Smith’s (1998) “approximate aggregation” result as showing heterogeneous- and representative-agent dynamics are essentially the same – the paper outlines an emerging Heterogeneous Agent New Keynesian (HANK) framework, built on Kaplan, Moll, and Violante (2018), that gives households access to both a low-return liquid asset and a high-return illiquid asset subject to a transaction cost. Simulating a consistently calibrated HANK model against its representative-agent (RANK) counterpart, the authors introduce a three-way taxonomy of “strong,” “weak,” and “non-equivalence” between the two frameworks and show, through a discount-factor (demand) shock, a total-factor-productivity shock, a monetary policy shock, and government spending and transfer shocks, that the degree of equivalence depends entirely on which shock is analyzed: demand shocks are strongly equivalent, TFP shocks produce similar aggregate paths through different mechanisms, and monetary and fiscal shocks generate starkly different aggregate responses because HANK consumption is far more sensitive to current disposable income and far less sensitive to interest-rate changes than RANK consumption. The paper’s second message is that heterogeneous-agent models open up macroeconomic questions that representative-agent models cannot even pose – microfounding a fall in aggregate demand through tighter credit limits or higher idiosyncratic income risk, using the cross-sectional pattern of a shock’s transmission to help identify its source, and studying how aggregate shocks and stabilization policy reshape household inequality – and it closes by naming seven directions (real wage and product-market frictions, labor-market microfoundations, gross and nominal balance sheets, time-varying risk premia, financial intermediaries, non-rational-expectations, and optimal policy) along which the still-“infant” HANK framework needs further development.

Monetary Policy According to HANK

This paper revisits the transmission mechanism from monetary policy to household consumption using a quantitative Heterogeneous Agent New Keynesian (HANK) model built to match the empirical distribution of household income, liquid wealth, and illiquid wealth. On the household side, the model extends the standard Aiyagari-Huggett-Imrohoroglu incomplete-markets framework, following Kaplan and Violante (2014), to let households save in a low-return liquid asset and a high-return illiquid asset subject to a transaction cost – a structure that, unlike one-asset incomplete-markets models, can simultaneously match a high aggregate wealth-to-output ratio and a realistically large marginal propensity to consume out of small windfalls. The paper’s central finding decomposes the aggregate consumption response to an interest rate cut into a “direct effect” (intertemporal substitution, operating even absent any income change) and an “indirect effect” (the general-equilibrium rise in labor demand and income that follows from the direct impulse): in representative-agent New Keynesian (RANK) models, direct effects account for nearly the entire response, but in the calibrated HANK model, indirect effects account for about 80 percent of the response and direct effects for only about 20 percent – a result the authors show is highly robust across specifications. The reversal is driven by the coexistence of poor and wealthy hand-to-mouth households (insensitive to interest rates but highly sensitive to income) and by dampened intertemporal substitution even among non-hand-to-mouth households, due to liquidity-constraint risk and portfolio rebalancing toward illiquid assets. A second major finding is that, because the government is a large issuer of liquid assets, Ricardian equivalence fails in this environment, so the specific fiscal response accompanying a monetary shock (transfers, taxes, spending, or government debt absorbing the change in interest payments) materially changes the overall size and timing of monetary policy’s effect on the economy – a dependence entirely absent from RANK models.

Quantitative Macroeconomics with Heterogeneous Households

This review article surveys the quantitative macroeconomics literature that models household heterogeneity, centering on the “standard incomplete markets” (SIM) model in which a continuum of ex ante identical households face uninsurable idiosyncratic shocks and self-insure via a single risk-free asset, building on Bewley (1983), Aiyagari (1994), and Huggett (1993). The authors organize the literature around three themes: first, the sources of individual risk and heterogeneity – persistent versus transitory earnings shocks, heterogeneity in initial conditions, and the endogenous component of income dynamics arising from labor supply, job search, and human capital choices, plus emerging work on health and family shocks; second, households’ channels of insurance beyond the risk-free bond – financial markets (including default and housing), flexible labor supply, the family, and government tax-and-transfer programs; and third, how idiosyncratic risk interacts with aggregate risk, covering the Krusell-Smith (1998) computational method and its “approximate aggregation” result, and the implications of heterogeneity for the welfare costs of business cycles, the welfare costs of inflation, and the equity premium puzzle. The authors argue that first-generation SIM models – with only exogenous earnings shocks and only saving as insurance – have since been substantially extended along all three dimensions, though unevenly, and they close by identifying the relationship between idiosyncratic and aggregate risk as the least well understood dimension and a priority for future research.

The Marginal Propensity to Consume in Heterogeneous Agent Models

This review conducts a systematic investigation of the size and determinants of the aggregate marginal propensity to consume (MPC) in heterogeneous-agent incomplete-markets models – models whose defining features are uninsurable idiosyncratic income risk, a precautionary saving motive, and an endogenous wealth distribution. Motivated by empirical evidence that the average quarterly MPC out of a $500-$1,000 transitory income change is between 15% and 25%, with substantial dispersion across households, Kaplan and Violante ask what model features and calibration strategies allow this class of models to reproduce that evidence while remaining consistent with the observed household wealth distribution. Their central finding is that there is an unavoidable tension in the canonical one-asset precautionary-saving model: calibrated to match aggregate US wealth, it generates an average quarterly MPC of only 3-5%, an order of magnitude larger than in representative-agent models but still far below the data; calibrations that instead target liquid wealth or the empirical share of hand-to-mouth households can match observed MPCs, but only by ignoring more than 98% of aggregate wealth; and extensions with ex-ante heterogeneity in discount factors, returns, or elasticities of intertemporal substitution, or with behavioral preferences (temptation, present bias), can generate realistic average MPCs while matching aggregate wealth, but only by producing an excessively polarized wealth distribution that understates the wealth of households in the middle of the distribution – the “missing middle” problem – with median wealth 5 to 10 times too small. Two-asset models, which separate a low-return liquid asset from a higher-return illiquid asset subject to adjustment costs, can resolve this tension because they generate “wealthy hand-to-mouth” households (holding illiquid but little liquid wealth) alongside poor hand-to-mouth households, but the authors show this requires a sizable gap between liquid and illiquid returns (about 8 percentage points annually in their baseline calibration), and they discuss extensions – direct utility flows from illiquid assets such as housing, or commitment/temptation motives – that can achieve the same fit with a smaller return gap.