the distribution of money and prices in search equilibrium this article considers a search theoretic model of monetary exchange agents bargain over both the amount of money and the quantity of goods to be exchanged in bilateral meetings determining endogenously the distributions of money and of prices i show that money is neutral if changes in the money supply are accomplished via proportional transfers however within the class of lump sum transfers an increase of the rate of monetary expansion tends to decrease the dispersion of wealth and prices and to improve welfare when inflation is low but when inflation is high enough the opposite effects occur

endogenous trading constraints with incomplete asset markets abstract this paper endogenizes the borrowing constraints on capital in a production economy with incomplete markets we find that these limits get looser with income a property that is consistent with us data on credit limits the framework with endogenous limits is then used to study the effects of a revenue neutral tax reform that eliminates capital income taxes our results illustrate that it is very important to take into account the effects of tax policies on the limits throughout the transition these effects can be big enough to change the overall conclusion about the desirability of a tax reform

an overlapping generations model for monetary policy analysis abstract we integrate an overlapping generations structure into the standard lagos and wright 2005 framework and show that mild inflation can be welfare improving the reason behind this result is that inflation induces young agents to reduce their savings and to increase their consumption which overpowers the utility loss of old agents however the beneficial effect disappears for higher inflation rates such that the optimal inflation rate is one at an intermediate level

a simple asset pricing model with heterogeneous agents uninsurable labor income and limited stock market participation abstract in this paper we study a simple two period asset pricing model to understand the implications of uninsurable labor income risk and or borrowing constraints limited stock market participation heterogeneous labor income volatilities and heterogeneous preferences we appraise the performance of each of these in matching moments of asset returns to the data and show that limited stock market participation generates a significantly large equity premium we also show that the distribution of wealth between stock market participants and non participants plays an important role in asset pricing and that the effect of borrowing constraints on asset returns are similar to that of limited participation finally we discuss the practical implications of our investigation providing an appraisal of ongoing changes in asset returns

volatility clustering in real interest rates theory and evidence abstract in this paper we document that the volatility of monthly real interest rates is characterized by long periods of relatively constant volatility interrupted by short periods of sharp increases in volatility moreover volatility is correlated with measures of economic activity and financial market frictions in particular the conditional variance of real interest rates is negatively correlated with the growth rate of industrial production and positively correlated with the spread between the borrowing and the lending rate we develop an equilibrium model with financial frictions that is able to mimic the observed behavior of the volatility of interest rates the model can explain the negative correlation of the conditional variance with the business cycle and the positive correlation with the spread between the borrowing and the lending rate

does market incompleteness matter this paper argues that incompleteness of intertemporal financial markets has little effect on welfare prices or consumption in an economy with a single consumption good provided that traders are long lived and patient a riskless bond is traded shocks are transitory and there is no aggregate risk in an economy with aggregate risk a similar conclusion holds provided traders share the same crra utility function and the right assets are traded examples demonstrate that these conclusions need not hold if the wrong assets are traded or if the economy has multiple consumption goods

trying to explain home bias in equities and consumption investors hold a substantially larger proportion of their wealth portfolios in domestic assets than standard portfolio theory would suggest a phenomenon called equity home bias in the absence of this bias investors would optimally diversify domestic output risk using foreign equities therefore consumption growth rates would tend to co move across countries even when output growth rates do not empirically however consumption growth rates tend to have a lower correlation across countries than do output growth rates a phenomenon i call consumption home bias in this paper i discuss these two biases and their potential relationship as suggested by the literature

inflation and welfare in a monetary economy it is in everyone s private interest to try to get someone else to hold non interest bearing cash and reserves but someone has to hold it all so these efforts must simply cancel out all of us spend several hours per year in this effort and employ thousands of talented and highly trained people to help us these person hours are simply thrown away wasted on a task that should not have to be performed at all

optimal vs traditional securities under moral hazard this paper provides an explanation for the widespread use of traditional securities by wellestablished firms standard moral hazard models predict that equity debt and warrants are almost never optimal financing instruments i show that issuing these securities is nevertheless nearly optimal the issuer would gain very little by using non traditional securities instead combined with equity one debt issue without multiple layers of seniority and one warrant issue without multiple exercise prices suffice to achieve near optimality the near optimality of traditional financing depends crucially on the issuer s ability to use war rants in addition to debt and equity

trading horizons and the value of money abstract this paper shows that fiat money can be feasible and essential even if the trading horizon is finite and deterministic the result hinges on two features of our model first individual actions can affect the future availability of productive resources so agents may be willing to sell for money even if on that date they have no reason to accept it this makes monetary trade feasible in all preceding dates second agents are anonymous and direct their search for partners so gift giving arrangements may be prevented because agents can misrepresent their consumption needs this makes money essential in exploiting any gains from specialization and trade

computing multi period information constrained optima this paper presents a detailed theoretical derivation and justification for methods used to compute solutions to a multi period including infinite period continuum agent unobservedeffort economy actual solutions are displayed illustrating cross sectional variability in consumption and labour effort in the population at a point in time and variability for a typical individual over time the optimal tradeoff between insurance and incentives is explored and the issue of excess variability is addressed by consideration of the analogue full information economy and various restricted contracting regimes

can monetizing trade lower welfare an example abstract in decentralized trade individuals self insure against consumption risk via costly diversification of skills although money acts as consumption insurance it may lead to a moral hazard problem if the problem is severe monetizing trade can lower welfare relative to barter

incomplete markets borrowing constraints and the foreign exchange risk premium abstract this paper solves a model consisting of two monetary economies with incomplete markets in which agents are subject to borrowing constraints the paper investigates if such a framework is able to account for the volatility and the size of the foreign exchange risk premium the model succeeds in increasing substantially the volatility of the risk premium to about 30 of that in the data however this more volatile risk premium does not translate into sufficiently large predictable excess returns it thus appears unlikely that excess returns from currency speculation can be uniquely explained by a time varying risk premium in an incomplete markets economy with exogenous borrowing constraints

asset prices in a huggett economy this paper explores asset pricing in economies where there is no direct insurance against idiosyncratic risks but other assets can be used for self insurance subject to exogenously imposed borrowing limits we analyze an endowment economy based on huggett 1993 11 both with and without aggregate risk our main innovation is that we obtain full analytical tractability by studying the case with maximally tight borrowing constraints we illustrate by looking at riskless bonds equity and the term structure of interest rates and we show that the model can reproduce many features of observed asset prices when idiosyncratic risks are quantitatively reasonable

on the future of macroeconomics a new monetarist perspective this article argues that a pressing goal for macroeconomics is to incorporate financial considerations but we need models with solid microfoundations in particular the use of assets in facilitating exchange as well as different credit or other financial arrangements should be outcomes of not inputs to theories as a preview i suggest that mainstream macro does a good job explaining many phenomena and a financial crisis does not disprove such theory but understanding crises requires better incorporating factors related to money credit banking and liquidity the approach called new monetarist economics can help a lot in this regard

equilibrium in securities markets with heterogeneous investors and unspanned income risk abstract in a finite time horizon incomplete market continuous time setting with dividends and investor incomes governed by arithmetic brownian motions we derive closed form solutions for the equilibrium risk free rate and stock price for an economy with finitely many heterogeneous cara investors and unspanned income risk in equilibrium the sharpe ratio is the same as in an otherwise identical complete market economy whereas the risk free rate is lower and consequently the stock price is higher the reduction in the risk free rate is highest when the more risk averse investors face the largest unspanned income risk

a search theoretic approach to monetary economics the essential function of money is its role as a medium of exchange the authors formalize this idea using a search theoretic equilibrium model of the exchange process that captures the double coincidence of wants problem with pure barter one advantage of the framework described here is that it is very tractable the authors also show that the model can be used to addre ss some substantive issues in monetary economics including the potenti al welfare enhancing role of money the interaction between specializat ion and monetary exchange and the possibility of equilibria with multip le fiat currencies copyright 1993 by american economic association

gift exchange versus monetary exchange theory and evidence abstract we study the lagos and wright 2005 model of monetary exchange in the laboratory with a finite population of sufficiently patient agents this model has a unique monetary equilibrium and a continuum of non monetary gift exchange equilibria some of which pareto dominate the monetary equilibrium we find that subjects avoid the gift exchange equilibria in favor of the monetary equilibrium we also study versions of the model without money where all equilibria involve non monetary gift exchange we find that welfare is higher in the model with money than without money suggesting that money plays a role as an efficiency enhancing coordination device jel c92 d12 e40 z13

the distribution of money balances and the nonneutrality of money recent monetary models with explicit microfoundations are made tractable by assuming that agents have access to centralized markets after one round of decentralized trade given quasi linear preferences this makes the distribution of money degenerate which keeps the models simple but precludes the discussion of distributional effects of monetary policy we generalize these models by assuming two rounds of trade before agents can readjust their money holdings to study a range of new distributional effects analytically we show that unexpected symmetric lump sum money injections may increase short run output and welfare whereas asymmetric injections may increase long run output and welfare

a divisible search model of fiat money this paper extends the kiyotaki wright search model of fiat money to allow for divisible money and goods the extension allows me to examine the standard issues in monetary economics such as the neutrality and superneutrality of money by severing the artificial link in the kiyotaki wright model between the money supply and the number of money holders it is shown that money is neutral but not superneutral money growth generates a trading opportunity effect it changes the fraction of different agents in the economy and hence changes the probability with which agents have a successful match in addition money growth has a negative effect on the real money balance that is familiar in walrasian monetary models the balance of the two effects can imply a positive optimal money growth rate

testing heterogeneous agent models an alternative aggregation approach abstract starting from the cross sectional aggregation of marginal utilities rather than intertemporal marginal rates of substitution this paper develops a new heterogeneous agent pricing kernel a closed form version of the new kernel depends on changes in the cross sectional variance of log consumption rather than the variance of changes in log consumption as in constantinides and duffie 1996 asset pricing with heterogeneous consumers journal of political economy 104 219 237 we implement the new kernel on household consumption data from the consumer expenditure survey cex at monthly and quarterly horizons the new kernel reconciles the premium on u s equities with the consumption of asset holders for reasonable values of relative risk aversion the new kernel also fares better than kernels based on the aggregation of intertemporal marginal rates of substitution in explaining the cross sectional variation of risk premia on stocks and bonds portfolios mimicking changes in the cross sectional variance of log consumption for asset holders command significant negative sharpe ratios

capital mobility and international sharing of cyclical risk this paper investigates whether the international globalization of financial markets allows for significant cross country risk sharing at the business cycle frequency we find that cross country risk sharing is still limited and this is unlikely to be the result of financial frictions that limit state contingent contracts part of the limited international risk sharing could be the consequence of frictions that de facto reduce the short term mobility of financial capital but even with these frictions we find significant divergence between model predictions and the data

liquidity redistribution and the welfare cost of inflation abstract the long run welfare costs of inflation are studied in a micro founded model with trading frictions and costly liquidity management by modelling the liquidity management decision the model endogenizes the responses of velocity output the degree of market segmentation and the distribution of money compared to the traditional estimates based on a representative agent model the welfare costs of inflation are significantly smaller due to distributional effects of inflation the welfare cost of increasing inflation from 0 to 10 is 0 62 of consumption for the us economy furthermore the welfare cost is generally non linear in the inflation rate

portfolio claustrophobia asset pricing in markets with illiquid assets many classes of assets are illiquid or nonmarketable in that they cannot always be traded immediately thus a portfolio position in these becomes at least tem porarily irreversible we study the asset pricing implications of this type of illiquidity in an exchange economy with heterogeneous agents in this market one asset is always liquid the other asset can be traded initially but then not again until after a blackout period illiquidity has a dramatic effect agents abandon diversification and choose polarized portfolios instead the value of liquidity can represent a large portion of the equilibrium price of an asset jel g11 g12

money and the gains from trade this article studies the role of money in environments where in each meeting there is a double coincidence of real wants traders who meet at random finance their purchases through current production the sale of divisible money or both it is shown that in the absence of valued money if traders have asymmetric tastes for each other s good they produce and exchange socially inefficient quantities with valued money however traders exchange efficient quantities if the asymmetry of tastes is not too large it is shown that the gains from trade in the monetary economy are strictly greater than those in the corresponding barter economy that the friedman rule holds and that the allocation of resources in the monetary economy converges to the allocation in the barter economy as the growth rate of the money supply is increased

optimal multiperiod contracts and the gain from enduring relationships under private information informational asymmetries can play a key role in explaining the existence and nature of multiperiod contracts in an illustrative risk sharing model even relatively short two period contracts can be mutually beneficial if there is private information though one period contracts suffice otherwise further contracts which are pareto optimal relative to the environment and the information structure are defined and partially characterized an example illustrates how otherwise inefficient intertemporal tie ins can be used optimally to mitigate incentive problems the obvious borrowing lending schemes are not private information pareto optimal in these period by period actions are not sufficiently constrained discounting affects the form of the optimal contract but none of these qualitative conclusions

nonconvex factor adjustments in equilibrium business cycle models do nonlinearities matter recent empirical analysis has found nonlinearities to be important in understanding aggregated investment using an equilibrium business cycle model we search for aggregate nonlinearities arising from the introduction of nonconvex capital adjustment costs we find that while such costs lead to nontrivial nonlinearities in aggregate investment demand equilibrium investment is effectively unchanged our finding based on a model in which aggregate fluctuations arise through exogenous changes in total factor productivity is robust to the introduction of shocks to the relative price of investment goods

money and credit redux do we need both money and credit in models with explicit roles for payment instruments we show the answer is no if credit is easy money is useless if credit is tight money can be essential but then credit is irrelevant and changes in debt limits are neutral real balances respond endogenously to leave total liquidity constant this is true for exogenous or endogenous policy and debt limits secured or unsecured credit and fairly general preferences and pricing mechanisms while we also show how to overturn some results the benchmark model suggests credit conditions matter less than some people think

the welfare cost of inflation in canada and the united states abstract this paper follows lucas econometrica 68 2000 247 and estimates the welfare cost of inflation in the post world war ii canadian and u s economies we use recent advances in the field of applied econometrics to estimate the interest elasticity of money demand and report significantly smaller welfare costs estimates than lucas econometrica 68 2000 247

generalized search theoretic models of monetary exchange abstract virtually all simple search models of money assume agents with money cannot produce and so everyone has either 0 or 1 units of money in steady state we alternatively assume agents can always produce and simply restrict money inventories to 0 or 1 this seems better for many issues for example in the standard model it is difficult to interpret increases in the money supply because increasing the fraction of agents holding money decreases the economy s productive capacity our model avoids these problems and thus delivers more natural and simpler implications in many contexts we compare results on existence multiplicity and welfare across models

indivisible labor lotteries and equilibrium abstract this paper considers an economy where labor is indivisible and agents are identical although the discontinuity in labor supply at the individual level disappears as a result of aggregation it is shown that indivisible labor has strong consequences for the aggregate bahavior of the economy it is also shown that optimal allocations involve lotteries over employment and consumption

saving and liquidity constraints this paper is concerned with the theory of saving when consumers are not permitted to borrow and with the ability of such a theory to account for some of the stylized facts of saving behavior the models presented in the paper seem to account for important aspects of reality that are not explained by traditional life cycle models copyright 1991 by the econometric society

the redistributive effects of inflation and the shape of money demand abstract i quantify the distributional effects of expected inflation in a sample of oecd countries using a microfounded model of money where agents differ in their consumption risk against which they can insure using money and government bonds the model is calibrated using harmonized wealth microdata from the luxembourg wealth study i find that the inflation tax is progressive for low inflation levels but it becomes regressive as inflation increases cut off points vary across countries and depend on discount factors and heterogeneity in consumption risk across agents moreover i find that the magnitude of inflation s distributional impact depends not only on wealth distribution but also and importantly on the curvature and height of the money demand curve indeed a higher and less elastic money demand leads to more regressive effects of inflation thus implying such effects are not necessarily stronger in a country with a more unequal wealth distribution

assessing the accuracy of the aggregate law of motion in models with heterogeneous agents this paper shows that the r2 and the standard error have fatal flaws and are inadequate accuracy tests using data from a krusell smith economy i show that approximations for the law of motion of aggregate capital for which the true standard deviation of aggregate capital is up to 14 119 higher than the implied value and which are thus clearly inaccurate can have an r2 as high as 0 9999 0 99 key in generating a more powerful test is that predictions of the aggregate law of motion are not updated with the aggregated simulated individual data

infinite horizon incomplete markets the model of general equilibrium with incomplete markets is a generalization of the arrow debreu model which provides a rich framework for studying problems of macroeconomics this paper shows how the model which has so far been restricted to economies with a finite horizon can be extended to the more natural setting of an open ended future thereby providing an extension of the finite horizon representative agent models of modern macroeconomics to economies with heterogeneous agents and incomplete markets there are two natural concepts of equilibrium over an infinite horizon which prevent agents from entering into ponzi schemes that is from indefinitely postponing the repayment of their debts the first is based on debt constraints which place bounds on debt at each date event the second is based on transversality conditions which limit the asymptotic rate of growth of debt the concept of an equilibrium with debt constraint is a natural concept of equilibrium for macroeconomic analysis however the concept of an equilibrium with transversality condition is more amenable to theoretical analysis since it permits the powerful techniques of arrow debreu theory to be carried over to the setting of incomplete markets in an economy in which agents are impatient expressed by the mackey continuity of their preference orderings and have a degree of impatience at each date event which is bounded below a concept defined in the paper we show that the equilibria of an economy with transversality condition coincide with the equilibria with debt constraints an equilibrium with transversality condition is shown to exist it follows that for each economy there is an explicit bound m such that an equilibrium with explicit debt constraint m exists in which the constraint is never binding this latter property ensuring that the debt constraint whose objective is to prevent ponzi schemes does not in itself introduce a new imperfection into the model over and above the incompleteness of the markets

genetic variation in financial decision making individuals differ in how they construct their investment portfolios yet empirical models of portfolio risk typically account only for a small portion of the cross sectional variance this paper asks whether genetic variation can explain some of these individual differences following a major pension reform swedish adults had to form a portfolio from a large menu of funds we match data on these investment decisions with the swedish twin registry and find that approximately 25 of individual variation in portfolio risk is due to genetic variation we also find that these results extend to several other aspects of financial decision making

on the efficiency of monetary exchange how divisibility of money matters abstract we use alternative assumptions about the divisibility of goods and money and the ability of agents to use lotteries on money to investigate to what extent the indivisibility of money is the cause for the typically inefficient production and consumption decisions in search theoretic models of money our framework potentially generates three types of inefficiencies the no trade inefficiency where no trade takes place even though it would be socially efficient to trade and the too much trade and too little trade inefficiencies where the quantities produced and exchanged are either larger or smaller than what the solution to a social planner s problem would mandate it is shown that while the no trade and the too much trade inefficiencies are caused by the indivisibility of money the too little trade inefficiency remains even when money is divisible unless it is sufficiently valued

financial sophistication and the distribution of the welfare cost of inflation abstract the welfare cost of anticipated inflation is quantified in a calibrated model of the u s economy that exhibits tractable equilibrium dispersion in wealth and earnings inflation does not generate large losses in societal welfare yet its impact varies noticeably across segments of society depending also on the financial sophistication of the economy if money is the only asset then inflation mostly hurts the wealthier and more productive agents while those poorer and less productive may even benefit from inflation the converse holds in a more sophisticated financial environment where agents can insure against consumption risk with assets other than money

search limited participation and monetary policy a model is developed that employs recent developments in the literature on search models of money to capture the distributional effects of monetary policy in a tractable way deterministic and stochastic versions of the model are studied money is not neutral and these nonneutralities persist whether or not the change in the money supply is anticipated or unanticipated at the optimum monetary policy is geared to correcting distortions in the search sector of the economy while correcting for the persistent effects of past monetary policy actions there is no consensus among macroeconomists concerning the role of monetary policy in the short run however an influential idea is that limited participation in financial markets is an important mechanism behind the short run macroeconomic effects of central bank actions that is there is a component of economic activity that is centralized and interconnected this economic activity involves financial transactions among banks and other financial intermediaries and the agents who hold the assets and liabilities of these financial intermediaries when the central bank injects outside money into the economy or withdraws it the economic agents who are immediately affected by the monetary injection or withdrawal are the participants in these centralized transactions other economic agents who are engaged in more decentralized and less interconnected transactions will not be affected directly by the first round effects of central bank actions thus there will be a distributional effect of monetary injections and withdrawals as first captured in heterogeneous agent models by grossman and weiss 1983 and rotemberg 1984 this distributional effect will matter in interesting ways for the price level nominal interest rates aggregate output foreign exchange rates and the distribution of consumption across the population the grossman weiss and rotemberg models are not analytically tractable because of the difficulty in tracking the distribution of wealth over time however lucas 1990 fuerst 1992 and alvarez and atkeson 1997 among others

on the quantitative importance of market completeness abstract this paper quantitatively compares allocations in calibrated large overlapping generations growth models that only differ in their market structures for insuring against aggregate risk the findings are that the equilibrium behavior of aggregate variables is very similar across all market structures there are only minor differences the ratio of the volatility of aggregate consumption relative to that of investment is higher in complete market economies due partly to the higher volatility of consumption of older people it was also found that the risk premia in complete markets economies is basically zero therefore we can conclude that we can for the most part abstract from the issue of whether there exist markets for aggregate risk

asset returns with transactions costs and uninsured individual risk abstract we explore whether incorporating an explicit motive for holding liquid assets within an equilibrium asset pricing model helps explain the following features of asset returns and turnover in the post war u s economy i the low risk free real interest rate ii the large spread between returns on liquid assets and stocks and iii the greater transaction velocity of liquid assets relative to stocks we introduce a demand for liquid assets by adding uninsured individual risk together with differential costs of trading securities numerical simulations attempting to match the return data generate a ratio of liquid assets to income considerably below observed levels

accounting for forward rates in markets for foreign currency absteract forward and spot exchange rates between major currencies imply large standard deviations of both predictable returns from currency speculation and of the equilibrium price measure the intertemporal marginal rate of substitution representative agent theory with time additive preferences cannot account for either of these properties we show that the theory does considerably better along these dimensions when the representative agent s preferences exhibit habit persistence but that the theory fails to reproduce some of the other properties of the data in particular the strong autocorrelation of forward premiums since the advent of flexible exchange rates in the early 1970s a large body of statistical work has established that forward rates for major currencies are not optimal predictors of future spot rates relevant evidence is reported in studies by baillie lippens and mcmahon 1983 bekaert 1991 bilson 1981 boothe and longworth 1984 cumby 1988 cumby and obstfeld 1984 fama 1984 gregory and mccurdy 1984 hansen and hodrick 1983 hodrick and srivastava 1984 and korajczyk and viallet 1990 a more complete list of references is provided by hodrick 1987 these papers indicate that returns from speculation in forward and spot currency markets are predictable and that the predictable components vary considerably over time a number of alternative explanations have been offered for the predictable variation in foreign currency market excess returns kaminsky 1988 korajczyk 1985 and krasker 1980 suggest that infrequent extreme events may make returns appear predictable in small samples the so called peso problem lewis 1989 argues that rational learning following infrequent changes in the process governing equilibrium prices can explain part of the ex post predictability of currency returns froot and frankel 1989 and froot and thaler 1990 examine the hypothesis that market forecasts of future spot

incomplete markets and volatility abstract this paper shows that the precautionary motive combined with asset incompleteness is a major source of volatility and indeterminacy in financial markets price fluctuations originate from agents efforts to insure themselves through time by borrowing and lending instead of shifting income across states of nature by trading risky assets a high interest rate at a future date reduces the potential for future consumption smoothing via borrowing which leads to a strong precautionary motive and a low interest rate in the current period the negative feedback between future and current rates generates fluctuations this logic is developed in spec a cara normal exchange economy with many periods and endogenous interest rates when there is an intermediate level of market incompleteness and sufficient investor impatience fluctuations in the real interest rate can be large even though the aggregate endowment is constant spec has a unique equilibrium under a finite horizon on the other hand with a finite number of infinitely lived agents there exists a robust continuum of equilibria that are neither bubbles nor sunspots journal of economic literature classification numbers c61 d52 d58 g11 g12

comparison of solutions to the incomplete markets model with aggregate uncertainty abstract this paper compares numerical solutions to the model of krusell and smith 1998 income and wealth heterogeneity in the macroeconomy journal of political economy 106 867 896 generated by different algorithms the algorithms have very similar implications for the correlations between different variables larger differences are observed for i the unconditional means and standard deviations of individual variables ii the behavior of individual agents during particularly bad times iii the volatility of the per capita capital stock and iv the behavior of the higher order moments of the cross sectional distribution for example the two algorithms that differ the most from each other generate individual consumption series that have an average maximum difference of 1 63 11 4

uninsured idiosyncratic production risk with borrowing constraints the author analyzes a general equilibrium model of a heterogeneous agents economy in which the agents are subject to borrowing constraints and uninsurable idiosyncratic production risk

income and wealth heterogeneity in the macroeconomy how do movements in the distribution of income and wealth affect the macroeconomy we analyze this question using a calibrated version of the stochastic growth model with partially uninsurable idiosyncratic risk and movements in aggregate productivity our main finding is that in the stationary stochastic equilibrium the behavior of the macroeconomic aggregates can be almost perfectly described using only the mean of the wealth distribution this result is robust to substantial changes in both parameter values and model specification our benchmark model whose only difference from the representative agent framework is the existence of uninsurable idiosyncratic risk displays far less cross sectional dispersion and skewness in wealth than u s data however an extension that relies on a small amount of heterogeneity in thrift does succeed in replicating the key features of the wealth data furthermore this extension features aggregate time series that depart significantly from permanent income behavior

asset pricing puzzles and incomplete markets the representative agent theory of asset pricing is modified to incorporate heterogeneous agents and incomplete markets the model features two types of agents who differ up to a nontradable idiosyncratic component in their endowment processes numerical solutions indicate that individuals are able to diversify a substantial portion of their idiosyncratic income risk through riskless borrowing and lending alone restrictions on the variability of intertemporal marginal rates of substitution hansen and jagannathan 1991 are used to argue that incomplete markets as modeled here cannot account for the properties of asset returns that are anomalous from the perspective of representative agent theory a large literature in financial economics has investigated the extent to which variants of the lucas 1978 general equilibrium theory of asset pricing can account for the joint behavior of aggregate u s consumption and asset returns by and large this literature has concluded that a theory based upon frictionless arrow debreu markets and or a representative agent makes strongly counterfactual predictions regarding even the simple unconditional properties of this relationship mehra and prescott 1985 for instance show that the theory drastically underpredicts the average excess rate of return on u s stocks the so called equity premium puzzle weil 1989 points out as did mehra and prescott that the magnitude of the average risk free rate is far below that predicted by the theory this has been dubbed the risk free rate puzzle numerous authors including grossman melino and shiller 1987 and backus gregory and zin 1989 show that the theory cannot account for term premia inherent in the yield curve hodrick 1987 surveys a large literature which documents the theory s shortcomings in accounting for excess expected returns in foreign exchange markets the notion that the representative agent model cannot account for excess returns across a wide array of asset markets can be made more precise by using tools developed by hansen and jagannathan 1991 and shiller 1982

heterogeneity aggregate uncertainty and the short term interest rate this article analyzes the relationship between the short term interest rate and diversity i e the number of types in models with heterogeneous agents and incomplete markets the number of types needed to approximate a continuum varies across examples in all cases however the number of types has little effect on the average interest rate and consumption variability in these models the set of state variables is large because the equilibrium law of motion depends on the cross sectional wealth distribution the article shows how to solve these models numerically by approximating the distribution using moments or percentiles

uncertainty inflation and welfare this paper studies the welfare costs and the redistributive effects of inflation in the presence of idiosyncratic liquidity risk in a microfounded search theoretical monetary model we calibrate the model to match the empirical aggregate money demand and the distribution of money holdings across households and study the effects of inflation under the implied degree of market incompleteness we show that in the presence of imperfect insurance the estimated long run welfare costs of inflation are on average 40 to 55 smaller compared to a complete markets representative agent economy and that inflation induces important redistributive effects across households

full insurance in the presence of aggregate uncertainty this paper tests implications of full consumption insurance the object is to determine how much mileage can be obtained from a model with complete markets with such features as private information or liquidity constraints omitted the implication exploited is that individual consumption responds to aggregate risk but not to idiosyncratic risk the test involves regressing the change in household consumption onto the change in aggregate consumption and other right hand side variables such as the change in household income and change in employment status all variables other than the change in aggregate consumption are predicted to be insignificant in explaining the change in household consumption with observations on consumption and income for 10 695 households from the consumer expenditure survey the results are mixed the results for one specification exponential utility are mostly consistent with full consumption insurance the results for the other specification power utility are not

equilibrium asset prices with undiversifiable labor income risk abstract in a two period lucas tree economy in which ex ante identical but ex post dissimilar agents face undiversifiable labor income risk calibrating a wrong representative agent model results in overstating the equilibrium riskfree rate and in understating the equilibrium equity premium if the utility function exhibits decreasing absolute risk aversion and decreasing absolute prudence these behavioral assumptions provide as a consequence a theoretical rationale for the often advanced conjecture that nontraded risk contributes to the solution of the riskfree rate and equity premium puzzles

the welfare cost of inflation under imperfect insurance abstract this paper examines the welfare cost of inflation in an economy where agents hold money in order to smooth consumption in the face of income variability for which there is no insurance the findings indicate that for the type of economies considered here the area under the empirical money demand curve is a poor measure of the welfare cost of inflation this area accounts for only one fourth of the true costs in the case of 5 inflation

the time variation of risk and return in foreign exchange markets a general equilibrium perspective this article successively introduces variable velocity durability and habit persistence in a standard two country general equilibrium model and explores their effects on the variability of exchange rate changes forward premiums and the foreign exchange risk premium a new feature of the model is that agents make decisions at a weekly frequency and face conditionally heteroskedastic shocks nevertheless even the most complex model fails to deliver sufficiently variable risk premiums without causing forward premiums and exchange rates to be excessively variable unlike previous models the model can roughly match the persistence of forward premiums article published by oxford university press on behalf of the society for financial studies in its journal the review of financial studies

modeling earnings dynamics in this paper we use indirect inference to estimate a joint model of earnings employment job changes wage rates and work hours over a career we use the model to address a number of important questions in labor economics including the source of the experience profile of wages the response of job changes to outside wage offers and the effects of seniority on job changes we also study the dynamic response of wage rates hours and earnings to various shocks and measure the relative contributions of the shocks to the variance of earnings in a given year and over a lifetime we find that human capital accounts for most of the growth of earnings over a career although job seniority and job mobility also play significant roles unemployment shocks have a large impact on earnings in the short run as well as a substantial long term effect that operates through the wage rate shocks associated with job changes and unemployment make a large contribution to the variance of career earnings and operate mostly through the job specific error components of wages and hours

moral hazard imperfect risk sharing and the behavior of asset returns abstract this paper develops a model of endogenous idiosyncratic risk in a simple two period general equilibrium setting and examines its implications for the behavior of asset returns the model readily generates empirically plausible idiosyncratic risk in consumption and yields more realistic behavior of asset returns than comparable models with perfect insurance the most dramatic effects of imperfect risk sharing however are not on the spreads between asset returns but on their absolute levels overall the results suggest allowing for incomplete markets can contribute to a resolution of the equity premium puzzle

a unified framework for monetary theory and policy analysis search theoretic models of monetary exchange are based on explicit descriptions of the frictions that make money essential however tractable versions of these models typically make strong assumptions that render them ill suited for monetary policy analysis we propose a new framework based on explicit micro foundations within which macro policy can be studied the framework is analytically tractable and easily quantifiable we calibrate the model to standard observations and use it to measure the cost of inflation we find that going from 10 percent to 0 percent inflation is worth between 3 and 5 percent of consumption much higher than previous estimates

asset pricing with jump diffusion permanent income shocks abstract by assuming that all uninsurable risk is permanent a closed form multi period multiple agent and multiple asset incomplete market asset pricing model is presented that allows for jump as well as diffusion risk to personal income

asset pricing with limited risk sharing and heterogeneous agents we develop a model with incomplete markets and heterogeneous agents that generates a large equity premium while simultaneously matching stock market participation and individual asset holdings the high risk premium is driven by incomplete risk sharing among stockholders which results from the combination of aggregate uncertainty borrowing constraints and a realistically calibrated life cycle earnings profile subject to idiosyncratic shocks we show that it is challenging to simultaneously match asset pricing moments and individual portfolio decisions while limited participation has a negligible impact on the risk premium contrary to the results of models where it is imposed exogenously

incomplete markets liquidation risk and the term structure of interest rates we analyse the term structure of interest rates in a general equilibrium model with incomplete markets borrowing constraint and positive net supply of government bonds uninsured idiosyncratic shocks generate bond trades while aggregate shocks cause uctuations in the trading price of bonds long bonds command a liquidation risk premium over short bonds because they may have to be liquidated before maturity following a bad idiosyncratic shock precisely when their resale value is low due to the simultaneous occurrence of a bad aggregate shock our framework endogenously generates limited cross sectional wealth heterogeneity among the agents despite the presence of uninsured idiosyncratic shocks which allows us to characterise analytically the shape of the entire yield curve including the yields on bonds of arbitrarily long maturities agents desire to hedge the idiosyncratic risk together with their fear of having to liquidate long bonds at unfavourable terms imply that a greater bond supply raises the level of the yield curve while an increase in the relative supply of long bonds raises its slope

a simple test of consumption insurance are consumers effectively insured against idiosyncratic shocks to income or wealth either by formal institutions such as charities private insurance and government programs or by informal mechanisms such as gifts and loans from relatives friends and neighbors under full insurance consumption growth should be cross sectionally independent of idiosyncratic variables that are exogenous to consumers this proposition is tested by cross sectional regressions of consumption growth on a variety of exogenous variables full insurance is rejected for long illness and involuntary job loss but not for spells of unemployment loss of work due to strike and an involuntary move

on efficient distribution with private information this paper is a study of the dynamics of the efficient distribution of consumption in an exchange economy with many consumers each of whom is subject to private idiosyncratic taste shocks we propose a recursive method for finding feasible allocations that are incentivecompatible and that are pareto optimal within this set the method is applied to several parametric examples we find that in an efficient allocation the degree of inequality continually increases with a diminishing fraction of the population receiving an increasing fraction of the resources we discuss the extent to which these allocations can be decentralized via market arrangements this paper is a study of the dynamics of the efficient distribution of consumption in an exchange economy with private information the economy we study has a constant endowment flow of a single non storable consumption good which is to be allocated each period among a large number of consumers each period these consumers experience unpredictable idiosyncratic privately observed taste shocks affecting their marginal utility of current consumption efficiency dictates that more resources be allocated to those consumers who in any given period have a high marginal utility of current consumption

preferences inflation and welfare abstract this paper systematically examines how degrees of household risk aversion ra and elasticity of intertemporal substitution eis impact the welfare costs of inflation in a heterogeneous agent environment featuring capital and essential money empirical evidence suggests that households have degrees of ra and eis that differ on average from traditional values and display large amounts of dispersion capturing these empirical features of preference values in an otherwise standard model leads to welfare enhancements of inflation due to household substitution of money for capital the analysis also compares the welfare implications for alternative ways to implement monetary policy

monetary and fiscal policies in a heterogeneous agent economy i study the effects of long run inflation and income taxation in an economy where households face uninsurable idiosyncratic risks i construct a tractable competitive search framework that generates dispersion of prices income and wealth i analytically characterize the stationary equilibrium and the policy effects on individual choices quantitative analysis finds that monetary and fiscal policies have distinctive effects on macro aggregates such as output savings wealth dispersion income and consumption inequalities there can be a hump shape relationship between welfare and the respective policies overall welfare can be maximized by a deviation from the friedman rule paired with distortionary income taxation

leverage time preference and the equity premium puzzle abstract we re examine the mehra and prescott 1985 model a combination of the time preference factor greater than one and reasonable leverage ratios in the equity market resolve the equity premium puzzle such parameter values can be consistent with finite expected utility and a positive risk free rate of interest rate the model performs better for the mp target values than for economically reasonable variations around those values

cost of business cycles with indivisibilities and liquidity constraints it is almost universally agreed that individuals face incomplete insurance markets and cannot perfectly insure against the idiosyncratic risk in this paper simple general equilibrium models with incomplete insurance markets are examined in order to assess the impact of imperfect insurance on the magnitude of the welfare costs of business cycles two versions of incomplete insurance markets are considered and certain statistical properties of the equilibrium stochastic processes in these environments are compared with those of a perfect insurance economy

the risk free rate in heterogeneous agent incomplete insurance economies abstract why has the average real risk free interest rate been less than one percent the question is motivated by the failure of a class of calibrated representative agent economies to explain the average return to equity and risk free debt i construct an economy where agents experience uninsurable idiosyncratic endowment shocks and smooth consumption by holding a risk free asset i calibrate the economy and characterize equilibria computationally with a borrowing constraint of one year s income the resulting risk free rate is more than one percent below the rate in the comparable representative agent economy

the importance of the number of different agents in a heterogeneous asset pricing model abstract models with heterogeneous agents and incomplete markets often only have two types of agents to limit the computational complexity the question arises whether equilibrium models with a realistic number of types have the same implications as models with a small number of types in the asset pricing model considered in this paper several properties depend crucially on the number of types for example in the economy with only two types interest rates respond to idiosyncratic income shocks which makes it easier to smooth consumption moreover these effects can be so strong that it is possible that a relaxation of the borrowing constraint reduces an agent s utility average interest rates on the other hand are not very sensitive to the number of types

inflation and welfare in the steady state this is a paper on expected inflation and welfare in steady state equilibrium the demand for money is an inventory demand with an endogenous payment period the clower constraint is not imposed higher inflation reduces welfare by reducing consumption as people devote more of their real income to maintaining lower average money holdings high inflation does not necessarily promote an increase in the capital stock the mundell tobin effect is absent the policy conclusion is standard deflate at the rate of time preference because capital is held socially optimal consumption falls short of its golden rule level if inside money is allowed it drives out fiat money and welfare is again at a maximum

fiscal policy and asset prices with incomplete markets we study the simultaneous impact of fiscal policy decisions on macroeconomic activity wealth distribution and asset prices we consider a general equilibrium overlapping generations model with incomplete markets and heterogeneous agents where government debt and capital are imperfect substitutes increases in public debt lead to significant increases in the riskless rate and to a reduction in the equity premium while higher capital income tax rates lead to a higher equity premium the crowding out effects on capital and output are much higher than in models where government debt and capital are perfect substitutes which thus ignore households portfolio reallocation decisions the author 2012 published by oxford university press on behalf of the society for financial studies all rights reserved for permissions please e mail journals permissions oup com oxford university press

explaining bond returns in heterogeneous agent models the importance of higher order moments abstract this paper examines the higher order moments and nonlinear dynamic properties of discount bond returns in an equilibrium heterogeneous agent economy with incomplete markets and borrowing constraints we find that while it is possible for the economic model to match the mean and variance of the observed bond returns by choosing the parameters such that the borrowing constraint is binding sufficiently often the implied higher order moments are at odds with the data to match the higher order moments one needs a model in which the borrowing constraint is binding at times but not too often in this case one does not match the first two moments using the seminonparametric density estimation and the nonlinear impulse response analysis we find that our economic model can mimic the asymmetric effect of return shocks on conditional volatility as documented for the real bond returns however the economic model has difficulty replicating the dynamic properties observed in the data when the parameter values are chosen to match the first two moments of the observed bond returns

liquidity a new monetarist perspective this essay surveys the new monetarist approach to liquidity work in this literature strives for empirical and policy relevance plus rigorous foundations questions include what is liquidity is money essential in achieving desirable outcomes which objects can or should serve in this capacity when can asset prices differ from fundamentals what are the functions of commitment and collateral in credit markets how does money interact with credit and intermediation what can and should monetary policy do the research summarized emphasizes the micro structure of frictional transactions and studies how institutions like monetary exchange credit arrangements or intermediation facilitate the exchange process

a simple model of incomplete insurance the case of permanent shocks this paper constructs a simple model of incomplete insurance by introducing permanent idiosyncratic shocks into an ak type endogenous growth model as in the exchange economy of constantinides and duffie 1996 we define a no trading equilibrium using this model exploiting a simple closed form solution the paper examines several important implications including the effect of precautionary savings caused by uninsured shocks on consumption growth and asset pricing in particular on risk free rates of return the relation with representative agent models and the cross sectional consumption distribution

asset trading mechanisms and expansionary policy abstract previous authors have argued that the otimal monetary policy is contractionary if buyers value consumption substantially more than sellers there is some randomness and informational constraints make asset trading useful we show that there is an incentive compatible expansionary policy that dominates all incentive compatible contractionary policies

precautionary saving in the small and in the large the theory of precautionary saving is shown to be isomorphic to the arrow pratt theory of risk aversion making possible the application of a large body of knowledge about risk aversion to precautionary saving and more generally to the theory of optimal choice under risk in particular a measure of the strength of the precautionary saving motive analogous to the arrow pratt measure of risk aversion is used to establish a number of new propositions about precautionary saving and to give a new interpretation of the dreze modigliani substitution effect copyright 1990 by the econometric society

indivisibilities lotteries and monetary exchange we introduce lotteries randomized trading into search theoretic models of money in a model with indivisible goods and fiat money we show goods trade with probability 1 and money trades with probability where 1 iff buyers have sufficient bargaining power with divisible goods a nonrandom quantity q trades with probability 1 and again money trades with probability where 1 iff buyers have sufficient bargaining power moreover q never exceeds the efficient quantity not true without lotteries we consider several extensions designed to get commodities as well as money to trade with probability less than 1 and to illuminate the efficiency role of lotteries

hedging derivative securities and incomplete markets an e arbitrage approach given a european derivative security with an arbitrary payoff function and a corresponding set of underlying securities on which the derivative security is based we solve the optimal replication problem find a self financing dynamic portfolio strategy involving only the underlying securities that most closely approximates the payoff function at maturity by applying stochastic dynamic programming to the minimization of a mean squared error loss function under markov state dynamics we derive recursive expressions for the optimal replication strategy that are readily implemented in practice the approximation error or e of the optimal replication strategy is also given recursively and may be used to quantify the degree of market incompleteness to investigate the practical significance of these e arbitrage strategies we consider several numerical examples including path dependent options and options on assets with stochastic volatility and jumps