Is Household Heterogeneity Important for Business Cycles?

This paper explores how the interaction between household heterogeneity and progressive government transfers shapes aggregate labor market ‡uctuations. Using a static model of the extensive margin labor supply, we analytically show that greater progressivity in the transfer system leads to greater volatility of low wage workers’ employment and less procyclical average labor productivity. We then build a dynamic general equilibrium model with both idiosyncratic and aggregate productivity shocks and show that household heterogeneity substantially shapes the dynamics of macroeconomic aggregates when interacted with progressive transfers. Specifically, a notable feature of the performance of our heterogeneous-agent model is its ability to reproduce moderately procyclical average labor productivity while retaining the success of the representative-agent indivisible labor model in generating a large cyclical volatility of aggregate hours relative to output. Finally, we document that among low-wage workers, (i) the individuallevel probability of adjusting labor supply along the extensive margin is signi…cantly higher, and (ii) the fall in employment rate is considerably steeper during the last six recessions, both of which support the key mechanism of our model.