Redistributive Policy Shocks and Monetary Policy with Heterogeneous Agents

Layer 1 — What this paper finds and why it matters

Governments in emerging market and developing economies (EMDEs) routinely intervene in agricultural markets — procuring grain and redistributing it to poor households — in response to food price shocks or expanded food security mandates (India’s 2013 National Food Security Act is the leading example). This paper asks how monetary policy should respond to such “redistributive policy shocks,” and what those shocks do to sectoral inflation and the consumption distribution between rich and poor households. The authors build a two-sector (agriculture with flexible prices; manufacturing with sticky prices), two-agent (Ricardian rich; rule-of-thumb poor) New Keynesian DSGE model, calibrated to India, that extends the TANK framework of Debortoli and Gali (2018) to two sectors and introduces explicit government procurement and redistribution. They show that a redistributive policy shock raises aggregate inflation and the output gap but also raises poor consumption and aggregate welfare, because the subsidy-in-kind effect on poor households more than offsets the decline in rich consumption and the inflationary pressure. They further show that consumer heterogeneity matters for whether monetary policy responses to various shocks raise or reduce aggregate welfare: in models with a flexible-price agricultural sector, contractionary monetary shocks produce larger deflation but smaller declines in real consumption relative to one-sector benchmarks, so the welfare cost of monetary contraction is lower than standard NK models imply.

Summary based on MPRA working paper (No. 101651, July 2020). The extracted PDF text was truncated before the calibration, impulse response, and welfare sections; quantitative parameter values and figure-level results are not available in the source text used here. AI-assisted, human review pending. See the linked original for authoritative claims.

Layer 2 — In depth

Q1. What is a “redistributive policy shock” and how does the model capture it?

A redistributive policy shock is a sudden increase in the fraction of government-procured agricultural output that is redistributed to poor households. In the model, the government taxes rich (Ricardian) households via lump-sum levies each period, uses those proceeds to purchase agricultural output at the open market price, and then redistributes a fraction φ_t of the procured quantity to poor households as an in-kind subsidy. The remaining fraction goes into a buffer stock. The shock to redistribution is modeled as a positive innovation to φ_t (AR(1) process), distinct from a shock to the procurement quantity Y^P_{A,t} itself. Because the in-kind transfer reduces the effective price paid by the poor for agricultural goods — the poor face an effective price of (1 − λ_t)P_{A,t} — the redistributive shock operates as a proportional price subsidy on agriculture consumption for the poor, even though the quantity is what the government directly controls.

Q2. What are the two types of households and how do they differ?

Rich households are Ricardian (forward-looking) and hold one-period risk-free bonds; poor households are rule-of-thumb consumers who do not save. Both types consume goods from both the agricultural and manufacturing sectors according to Cobb-Douglas indices, but they differ in three ways. First, poor households have a higher budget share for agricultural goods (δ_P > δ_R), consistent with Engel’s Law. Second, the inverse of the intertemporal elasticity of substitution (IES) is higher for the poor (σ_P > σ_R), following Atkeson and Ogaki (1996) estimates for Indian household data; this means the poor are less willing to substitute consumption across time and respond differently to real wage changes. Third, rich households have both labor income and dividend income from monopolistically competitive manufacturing firms, while poor households have only labor income.

Q3. What happens to inflation and consumption when a positive agricultural productivity shock hits?

A positive agricultural productivity shock leads to a decline in inflation, a rise in the output gap, and higher consumption for both rich and poor households. Because the agriculture sector has flexible prices, a positive productivity improvement lowers agricultural prices immediately, reducing the terms of trade (the relative price of agriculture to manufacturing). Aggregate CPI inflation falls. The rise in agricultural output increases real income for both household types, raising consumption and aggregate welfare. These dynamics are compared to the Aoki (2001) representative-agent two-sector benchmark.

Q4. What are the aggregate and distributional effects of a positive redistributive policy shock?

A procurement-and-redistribution shock raises aggregate inflation, the output gap, and poor consumption, while lowering rich consumption; aggregate welfare rises because the redistribution effect dominates. The mechanism has two parts. First, the government procures additional agricultural output at the market price, financed by higher lump-sum taxes on the rich; this reduces rich consumption. Second, the redistributed grain lowers the effective price of the agricultural good for the poor, raising poor consumption through a “redistribution effect.” Because poor households spend a higher share of income on the agricultural good than rich households, and because the poor receive a fraction of their agricultural consumption for free, market demand for the agricultural good in the open market is less than it would be without redistribution. Consequently, the inflationary impact of the procurement shock is substantially lower in the two-agent model than in the Aoki representative-agent model (where there is no redistribution to dampen open-market demand).

Q5. How does consumer heterogeneity alter the transmission of a contractionary monetary policy shock?

In models with a flexible-price agricultural sector, a contractionary monetary shock produces a larger deflation but a smaller decline in consumption and smaller welfare losses than in single-sector or representative-agent benchmarks. A rise in the nominal interest rate induces intertemporal substitution of consumption, reducing aggregate demand and the aggregate price level. This deflationary effect is amplified when a flexible-price sector is present alongside the sticky-price sector, because agricultural prices can fall immediately. However, the same flexible-price sector means that real interest rates rise by less (compared to an all-sticky-price economy), so the reduction in rich and poor consumption is also smaller. The paper compares this to three benchmarks: the simple one-sector one-agent NK model (Gali 2015, Chapter 3), the Debortoli-Gali (2018) one-sector two-agent model, and the Aoki (2001) two-sector one-agent model. The welfare losses from monetary contraction are lower in the two-sector models (the authors’ framework and Aoki’s) than in the one-sector models.

Q6. How does the model differ from its three main benchmark frameworks?

The model merges the two-sector production structure of Aoki (2001) with the TANK distributional structure of Debortoli and Gali (2018), and adds explicit government procurement and redistribution — none of the benchmarks have all three features. Relative to Aoki: the paper adds poor/rich heterogeneity, different IES parameters, and the government redistribution mechanism. Relative to Debortoli-Gali: the paper adds an agricultural flexible-price sector and the redistribution shock, and assumes complete markets (Debortoli-Gali assumes incomplete markets; their model is treated as an approximation). Relative to Gali (2015, Chapter 3): the paper adds both a second sector and household heterogeneity. The three differences from the simple NK benchmark in the Dynamic IS and NKPC equations are: (i) the presence of a terms of trade channel, (ii) heterogeneous agents with different IES parameters and budget shares, and (iii) redistribution policy that shifts the effective price index of the poor.

Q7. What role do terms of trade play in the model’s transmission mechanism?

The terms of trade between agriculture and manufacturing (T_t = P_{A,t}/P_{M,t}) is a central transmission variable that affects both aggregate consumption and inflation. Aggregate CPI inflation can be decomposed as π_t = δ_R·π_{A,t} + (1 − δ_R)·π_{M,t} = δ_R·ΔT_t + π_{M,t}, so movements in the terms of trade feed directly into headline inflation. Total agricultural and manufacturing consumption both depend on T_t, rich consumption C_{R,t}, and poor consumption C_{P,t} through equations (22) and (23). A rise in the terms of trade (higher relative agricultural prices) makes the consumption basket of the poor more expensive because they spend a larger share of income on agricultural goods, inducing them to reduce agricultural purchases. This terms-of-trade channel is absent from one-sector benchmarks and is a key reason the paper’s framework generates different aggregate dynamics than Debortoli-Gali.

Q8. What is the welfare metric used, and what is the paper’s welfare conclusion?

Welfare is defined to depend on aggregate consumption in the standard fashion, and the paper’s central welfare conclusion is that consumer heterogeneity matters for whether monetary policy responses to shocks raise or reduce aggregate welfare. For a redistributive policy shock, aggregate welfare rises despite higher inflation, because the gain in poor consumption (driven by the subsidy) exceeds the loss in rich consumption and the distortionary cost of inflation. For a contractionary monetary shock, welfare losses are smaller in the two-sector framework than in single-sector frameworks, because the flexible-price agricultural sector moderates the real interest rate increase and limits the consumption decline. The paper does not report specific numerical welfare loss figures in the portion of text available in this source extract.

Key concepts

Redistributive policy shock : in this paper’s usage, a positive shock to the fraction (φ_t) of government-procured agricultural output that is redistributed to poor households as an in-kind subsidy; distinct from a procurement level shock. Modeled as an AR(1) process on φ_t.

TANK (Two-Agent New Keynesian) model : a tractable heterogeneous-agent NK framework with exactly two household types — Ricardian (forward-looking, hold bonds) and rule-of-thumb (hand-to-mouth, do not save) — that Debortoli and Gali (2018) showed provides a good approximation to the aggregate dynamics of a full HANK model.

Rule-of-thumb (hand-to-mouth) consumers : households that maximize static utility subject to a static budget constraint, consuming all current income each period. In this model, the poor are rule-of-thumb consumers with only labor income and no bond holdings.

Effective price of agriculture for the poor : P’{A,t} = (1 − λ_t)P{A,t}, where λ_t is the fraction of poor agricultural consumption provided for free via the redistributive subsidy. The poor face a price index P’t = {(1−λ_t)P{A,t}}^{δ_P} · P_{M,t}^{1−δ_P}, which differs from the rich price index.

Terms of trade (TOT) : T_t = P_{A,t}/P_{M,t}, the relative price of the agricultural good to the manufactured good. Changes in TOT affect the sectoral composition of consumption for both household types and transmit through the Dynamic IS and NKPC equations.

Intertemporal elasticity of substitution (IES) : 1/σ_K for household type K. The paper assumes σ_P > σ_R (poor have lower IES than rich), following Atkeson and Ogaki (1996) estimates for Indian household data; this differential drives asymmetric labor supply responses to real wage changes.

Procurement shock : a shock to the quantity Y^P_{A,t} of agricultural output the government procures each period, modeled as a separate AR(1) process from the redistribution-fraction shock. Together, the procurement level and redistribution fraction determine the total subsidy received by poor households.