Jess Benhabib | Macro Paper Warehouse

Self-Fulfilling Fluctuations in HANK Economies

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

Research question and motivation: A central tenet of monetary policy is that aggressively raising nominal rates more than one-for-one with inflation (the Taylor principle) nips self-fulfilling inflationary beliefs in the bud. That logic is built on Representative-Agent New Keynesian (RANK) models that abstract from inequality and incomplete markets. Acharya and Benhabib ask whether this central tenet survives in Heterogeneous-Agent New Keynesian (HANK) economies where idiosyncratic income risk is countercyclical, and they answer in the negative: no matter how aggressively monetary policy responds to inflation, such economies remain susceptible to self-fulfilling fluctuations (“endogenous demand shocks”).

Aggregate demand externality and self-fulfilling default cycles

Research Question. Why do corporate defaults cluster in recurring episodes rather than occurring smoothly? The paper asks whether observable fundamental factors — firm characteristics and macroeconomic variables — are sufficient to account for the clustered default patterns documented in the data, and, if not, what theoretical mechanism can explain them.

Empirical Motivation. Using Moody’s historical default rate data, the authors document that the long-run average corporate bond default rate during 1866–2008 was approximately 1.50%, yet defaults were highly episodic: the worst three-year period during the Great Depression totaled 12.88%, and the three-year period 1873–1875 after the railroad boom reached 35.80%. A Markov switching regression on post-war default rate data (1951–2017) strongly rejects a linear no-switch model in favor of a two-regime model across all information criteria (AIC, HQ, SC, and log-likelihood). The estimated high-default regime has a mean default rate of 1.93% (unconditional mean µ/(1−ρ)) — roughly eight times the 0.23% mean of the low-default regime — and a standard deviation nearly six times larger. The high-default regime persists on average 5.81 years (transition probability of staying ≈ 0.83), while the low-default regime lasts approximately 7.52 years (staying probability ≈ 0.87).

Avoiding Liquidity Traps

Because a Taylor-type interest-rate rule must be consistent with the zero nominal-interest-rate bound, it always admits a second, unintended steady state with low or negative inflation alongside the intended target – and this paper shows that steady state is itself indeterminate, allowing the economy to slide into it via a self-fulfilling, gradually decelerating inflation path. Setting up a flexible-price, continuous-time monetary model in which the nominal rate is an increasing, nonnegative function of inflation and the Fisher equation pins the steady state relationship between the real rate, inflation, and the nominal rate, the paper shows this second intersection is unavoidable given the zero bound: inflation and the nominal rate are both low there, and “monetary policy is passive” in the technical sense long associated with equilibrium indeterminacy. Extending prior work (Benhabib, Schmitt-Grohé, and Uribe 2001b), the paper shows equilibrium paths exist that start arbitrarily close to the intended, Taylor-rule-consistent target and converge gradually to this unintended low-inflation trap – a self-fulfilling deflationary spiral driven by nothing but revisions in expectations, with all the hallmarks of a liquidity trap in which the central bank cannot reverse falling prices by cutting rates further, since rates are already near zero. The paper’s contribution is to design remedies that preserve the Taylor rule’s appealing local properties (including unique local determinacy near the inflation target) while ruling out the global liquidity-trap equilibrium: first, a fiscal policy in which government revenue’s sensitivity to outstanding liabilities rises with inflation, making the low-inflation path fiscally unsustainable via a transversality-condition violation (a Pigou-style wealth-effect channel, not the Keynesian multiplier); second, a conditional switch to a money-growth-rate target once inflation nears the trap, which the paper shows succeeds or fails depending critically on the accompanying fiscal regime. The paper’s flexible-price results extend, per the authors, to environments with sticky prices and to discrete time, though a distinct chaotic-dynamics failure mode of Taylor rules (identified in companion work) is not addressed by these remedies.