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.

Jonathan Heathcote | Macro Paper Warehouse

Quantitative Macroeconomics with Heterogeneous Households