Annual Review of Economics | Macro Paper Warehouse

Fiscal and Monetary Policy with Heterogeneous Agents

This paper reviews the Heterogeneous-Agent New Keynesian (HANK) literature that has emerged over the past decade, combining the canonical incomplete-markets model of income and wealth inequality (in the Bewley-Huggett-Aiyagari tradition) with the New Keynesian model of price and wage rigidity used to study monetary and fiscal policy. Rather than surveying disparate models, the authors build a single “canonical HANK model” – with sticky wages, flexible prices, and endogenous consumption-saving choice only (no endogenous labor supply) – calibrated to match realistic average marginal propensities to consume (MPCs) and a realistic wealth distribution, and use it to organize the field’s central results. Studying fiscal policy first, they show that a balanced-budget increase in government spending produces an output multiplier of exactly 1, identical to a representative-agent (RA) model, regardless of household heterogeneity (Proposition 1) – but a deficit-financed tax cut has much larger and more persistent effects in the heterogeneous-agent (HA) model than in either a representative-agent or two-agent (TA) model, because households partially save the tax cut, building up “excess savings” that low-MPC, poor households then spend down over time, an effect that “trickles up” toward wealthier households as it winds down. Turning to monetary policy, they show a subtler result: when steady-state government debt is zero, a monetary policy shock has an identical aggregate effect on output in HA, TA, and RA models (Proposition 2, generalizing a result first obtained by Werning 2015), because higher marginal propensities to consume are offset by lower sensitivity to future interest rates. Heterogeneity does not necessarily change the size of monetary policy’s aggregate effect, but it does change its transmission mechanism: decomposing the consumption response shows that “indirect” effects from labor income, capital gains, and government transfers dominate the “direct” interest-rate effect on saving decisions, a finding the authors attribute to Kaplan, Moll and Violante (2018). The paper then surveys a wide set of extensions – cyclical income risk, government debt maturity, nominal (rather than real) assets, behavioral frictions, the fiscal theory of the price level, illiquid two-account models, endogenous portfolio choice, and additional demand components such as investment and durable goods – and closes by noting that the literature has not yet reached a comparably mature theory of optimal monetary and fiscal policy in HANK models, in part because an unrestricted heterogeneous-agent economy typically lacks a well-defined Ramsey steady state to serve as a benchmark.

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.