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Incomplete Markets, Heterogeneity and Macroeconomic Dynamics

  • Bruce Preston
  • Mauro Roca

This paper solves a real business cycle model with heterogeneous agents and uninsurable income risk using perturbation methods. A second order accurate characterization of agent's optimal decision rules is given, which renders the implications of aggregation for macroeconomic dynamics transparent. The role of cross-sectional holdings of capital in determining equilibrium dynamics can be directly assessed. Analysis discloses that an individual's optimal saving decisions are almost linear in their own capital stock giving rise to permanent income consumption behavior. This provides an explanation for the approximate aggregation properties of this model documented by Krusell and Smith (1998): the distribution of capital does not affect aggregate dynamics. While the variance-covariance properties of endogenous variables are almost entirely determined by first order dynamics, the second order dynamics, which capture properties of the wealth distribution, are nonetheless important for an individual's mean consumption and saving decisions and therefore the mean equilibrium capital stock. Policy evaluation exercises therefore need to take account of these higher order terms.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 13260.

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Date of creation: Jul 2007
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Handle: RePEc:nbr:nberwo:13260
Note: EFG
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  17. Fernández-Villaverde, Jesús & Rubio-Ramírez, Juan Francisco, 2006. "Estimating Macroeconomic Models: A Likelihood Approach," CEPR Discussion Papers 5513, C.E.P.R. Discussion Papers.
  18. Eric R Young, 2005. "Approximate Aggregation," Computing in Economics and Finance 2005 141, Society for Computational Economics.
  19. Bewley, Truman, 1977. "The permanent income hypothesis: A theoretical formulation," Journal of Economic Theory, Elsevier, vol. 16(2), pages 252-292, December.
  20. Eric Swanson & Gary Anderson & Andrew Levin, 2006. "Higher-order perturbation solutions to dynamic, discrete-time rational expectations models," Working Paper Series 2006-01, Federal Reserve Bank of San Francisco.
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