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Incomplete Markets and Aggregate Demand

Listed author(s):
  • Iván Werning

I study aggregate consumption dynamics under incomplete markets, focusing on the relationship between consumption and the path for interest rates. I first provide a general aggregation result under extreme illiquidity (no borrowing and no outside assets), deriving a generalized Euler relation involving the real interest rate, current and future aggregate consumption. This provides a tractable way of incorporating incomplete markets in macroeconomic models, dealing only with aggregates. Although this relation does not necessarily coincide with the standard representative-agent Euler equation, I show that it does for an important benchmark specification. When this is the case, idiosyncratic uncertainty and incomplete markets leave their imprint by affecting the discount factor in this representation, but the sensitivity of consumption to current and future interest rates is unaffected. An immediate corollary is that “forward guidance” (lower future interest rates) is as powerful as in representative agent models. I show that the same representation holds with positive liquidity (borrowing and outside assets) when utility is logarithmic. I show that away from these benchmark cases, consumption is likely to become more sensitive to interest rate, and especially future interest rates. Finally, I apply my approach to a real business cycle economy, providing an exact analytical aggregation result that complements existing numerical results.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 21448.

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Date of creation: Aug 2015
Handle: RePEc:nbr:nberwo:21448
Note: EFG IFM ME
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  1. Veronica Guerrieri & Guido Lorenzoni, 2017. "Credit Crises, Precautionary Savings, and the Liquidity Trap," The Quarterly Journal of Economics, Oxford University Press, vol. 132(3), pages 1427-1467.
  2. Vincent Sterk & Silvana Tenreyro, 2013. "The Transmission of Monetary Policy Operations through Redistributions and Durable Purchases," CEP Discussion Papers dp1249, Centre for Economic Performance, LSE.
  3. S. Rao Aiyagari, 1994. "Uninsured Idiosyncratic Risk and Aggregate Saving," The Quarterly Journal of Economics, Oxford University Press, vol. 109(3), pages 659-684.
  4. Kaplan, Greg & Violante, Giovanni L, 2011. "A Model of the Consumption Response to Fiscal Stimulus Payments," CEPR Discussion Papers 8562, C.E.P.R. Discussion Papers.
  5. Ravn, Morten O. & Sterk, Vincent, 2017. "Job uncertainty and deep recessions," Journal of Monetary Economics, Elsevier, vol. 90(C), pages 125-141.
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