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When does heterogeneity matter?

  • Yi Wen
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How do movements in the distribution of income affect the macroeconomy? Krusell and Smith (1998) analyzed this question in a neoclassical growth model, and their results show that the representative-agent assumption provides a good approximation for aggregate behaviors of heterogeneous agents. This paper extends their analysis to a cash-in-advance model with heterogeneous money demand. It is shown that movements in the distribution of monetary income can have significant impact on the macroeconomy. For example, the dynamic responses of aggregate output to monetary shocks behave very differently from those of a representative agent; the welfare costs of moderate inflation are much higher than previously thought, up to 20% of consumption when the inequality of cash distribution is sufficiently large. This is in sharp contrast to the findings of Cooley and Hansen (1989) and Lucas (2000) based on representative-agent models.

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Paper provided by Federal Reserve Bank of St. Louis in its series Working Papers with number 2009-024.

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Date of creation: 2009
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Handle: RePEc:fip:fedlwp:2009-024
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  1. Orazio Attanasio & Luigi Guiso & Tullio Jappelli, 1998. "The Demand for Money, Financial Innovation, and the Welfare Cost of Inflation: An Analysis with Households' Data," CSEF Working Papers 03, Centre for Studies in Economics and Finance (CSEF), University of Naples, Italy.
  2. Cooley, T.F. & Hansen, G.D., 1988. "The Inflation Tax In A Real Business Cycle Model," Papers 88-05, Rochester, Business - General.
  3. Mankiw, N. Gregory & Reis, Ricardo, 2002. "Sticky Information Versus Sticky Prices: A Proposal to Replace the New Keynesian Phillips Curve," Scholarly Articles 3415324, Harvard University Department of Economics.
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  6. Ricardo Lagos & Randall Wright, 2005. "A Unified Framework for Monetary Theory and Policy Analysis," Journal of Political Economy, University of Chicago Press, vol. 113(3), pages 463-484, June.
  7. Julia K. Thomas, 2002. "Is lumpy investment relevant for the business cycle?," Staff Report 302, Federal Reserve Bank of Minneapolis.
  8. Aubhik Khan & Julia Thomas, 2007. "Inflation and interest rates with endogenous market segmentation," Working Papers 07-1, Federal Reserve Bank of Philadelphia.
  9. Per Krusell & Anthony A. Smith & Jr., 1998. "Income and Wealth Heterogeneity in the Macroeconomy," Journal of Political Economy, University of Chicago Press, vol. 106(5), pages 867-896, October.
  10. Robert E. Lucas, Jr., 2000. "Inflation and Welfare," Econometrica, Econometric Society, vol. 68(2), pages 247-274, March.
  11. Jovanovic, Boyan, 1982. "Inflation and Welfare in the Steady State," Journal of Political Economy, University of Chicago Press, vol. 90(3), pages 561-77, June.
  12. Makoto Nirei & Wataru Souma, 2007. "A Two Factor Model Of Income Distribution Dynamics," Review of Income and Wealth, International Association for Research in Income and Wealth, vol. 53(3), pages 440-459, 09.
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  14. Helpman, Elhanan, 1981. "An Exploration in the Theory of Exchange-Rate Regimes," Scholarly Articles 3445091, Harvard University Department of Economics.
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  17. Imrohoroglu, Ayse, 1992. "The welfare cost of inflation under imperfect insurance," Journal of Economic Dynamics and Control, Elsevier, vol. 16(1), pages 79-91, January.
  18. Hodrick, Robert J & Kocherlakota, Narayana R & Lucas, Deborah, 1991. "The Variability of Velocity in Cash-in-Advance Models," Journal of Political Economy, University of Chicago Press, vol. 99(2), pages 358-84, April.
  19. Chiu, Jonathan, 2014. "Endogenously Segmented Asset Market In An Inventory-Theoretic Model Of Money Demand," Macroeconomic Dynamics, Cambridge University Press, vol. 18(02), pages 438-472, March.
  20. Michael Dotsey & Peter Ireland, 1994. "The welfare cost of inflation in general equilibrium," Working Paper 94-04, Federal Reserve Bank of Richmond.
  21. Rotemberg, Julio J, 1984. "A Monetary Equilibrium Model with Transactions Costs," Journal of Political Economy, University of Chicago Press, vol. 92(1), pages 40-58, February.
  22. Aiyagari, S Rao, 1994. "Uninsured Idiosyncratic Risk and Aggregate Saving," The Quarterly Journal of Economics, MIT Press, vol. 109(3), pages 659-84, August.
  23. Blanchard, Olivier Jean & Kahn, Charles M, 1980. "The Solution of Linear Difference Models under Rational Expectations," Econometrica, Econometric Society, vol. 48(5), pages 1305-11, July.
  24. Carlos E. da Costa & Iván Werning, 2008. "On the Optimality of the Friedman Rule with Heterogeneous Agents and Nonlinear Income Taxation," Journal of Political Economy, University of Chicago Press, vol. 116(1), pages 82-112, 02.
  25. Imrohoruglu, Ayse, 1989. "Cost of Business Cycles with Indivisibilities and Liquidity Constraints," Journal of Political Economy, University of Chicago Press, vol. 97(6), pages 1364-83, December.
  26. Ireland, Peter N, 1996. "The Role of Countercyclical Monetary Policy," Journal of Political Economy, University of Chicago Press, vol. 104(4), pages 704-23, August.
  27. Svensson, Lars E O, 1985. "Money and Asset Prices in a Cash-in-Advance Economy," Journal of Political Economy, University of Chicago Press, vol. 93(5), pages 919-44, October.
  28. Grossman, Sanford & Weiss, Laurence, 1983. "A Transactions-Based Model of the Monetary Transmission Mechanism," American Economic Review, American Economic Association, vol. 73(5), pages 871-80, December.
  29. Lucas, Robert E, Jr, 1980. "Equilibrium in a Pure Currency Economy," Economic Inquiry, Western Economic Association International, vol. 18(2), pages 203-20, April.
  30. Fernando Alvarez & Andrew Atkeson & Chris Edmond, 2003. "On the Sluggish Response of Prices to Money in an Inventory-Theoretic Model of Money Demand," NBER Working Papers 10016, National Bureau of Economic Research, Inc.
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