Macroeconomics With Frictions

This article is a progress report on research that attempts to include one type of market incompleteness and frictions in macroeconomic models. The focus of the research is the absence of insurance markets in which individual-specific risks may be insured against. The article describes some areas where this type of research has been and promises to be particularly useful, including consumption and saving, wealth distribution, asset markets, business cycles, and fiscal policies. The article also describes work in each of these areas that was presented at a conference sponsored by the Federal Reserve Bank of Minneapolis in the fall of 1993. The views expressed herein are those of the author and not necessarily those of the Federal Reserve Bank of Minneapolis or the Federal Reserve System. The dominant modeling approach in macroeconomics so far has been to assume that markets in an economy are completeandfrictionless.Economists using this approach have assumed, in other words, that in the economy they are studying, markets exist for all possible trades that any individual might want to make, at any date and under any possible contingency, and that these markets operate without anyfrictions; individuals can buy and sell as much as they want in any market at given prices—without any constraints on borrowing in credit markets, for example, or on short sales in asset markets—and without any transaction costs. 1 While admittedly quite inconsistent with the characteristics of actual economies, this modeling approach has been the best macroeconomists have been able to use, and the approach has generally worked pretty well. Yet some puzzles it has simply not been able to solve. Apparently, for some issues, the incompleteness and frictions in actual economies are crucial. So another modeling approach, one that incorporates these characteristics, is necessary—and thanks to recent computational advances, some progress has been made in developing such an approach. To promote more progress, the Federal Reserve Bank of Minneapolis last year sponsored a conference which brought together much of the significant recent work of this type. The particular form of market incompleteness/frictions focused on at the conference is the absence of insurance markets in which individual-specific risks may be insured against. In this paper, I explain in detail why this modeling approach can be expected to have a significant impact on answers to questions of interest to macroeconomists and national policymakers. I provide some specific examples of topics in which this research has been or promises to be especially useful. I describe the contributions made by the papers presented at the Minneapolis Fed’s conference. And I describe what I see as the most fruitful directions for future research of this type. The Focus The reason for focusing on insurance markets is that, when compared with the standard approach, models with incompleteness and frictions in these markets are likely to have significantly different and empirically plausible implications for a variety of issues of interest to macroeconomists and policymakers. The new modeling approach incorporates the empirically plausible notion that individuals face substantially greater uncertainty at the individual level than that represented by fluctuations in aggregate variables like per capita consumption or per capita income—the types of fluctuations incorporated by standard models. Per capita consumption is notoriously smooth (fluctuating on average less than 1 percent from trend), and per capita income is only somewhat more variable (fluctuating on average less than 2 percent from trend). In contrast, individual earnings can fluctuate on average as much as 25 percent from trend. Presumably, the reason for the substantially greater uncertainty at the individual level is the inability to fully insure against individual-specific risks. For otherwise individuals would face no more uncertainty than that represented by fluctuations in per capita consumption or per capita income. In turn, the substantial uncertainty faced by individualsmusthave important implications forconsumption, saving, asset accumulation, and portfolio behavior. In addition to this substantially greater uncertainty faced by individuals, the new modeling approach includes market frictions like borrowing and short-sale constraints and transaction costs. These seem ubiquitous features of observedmarketswhichmake individuals’budgetconstraints quite different from what they would be otherwise. Generally speaking, such frictions can introduce kinks, nonlinearities, and even nonconvexities into individuals’ budget constraints. Some Sample Topics Thus, the combination of incomplete insurance markets and frictions is likely to lead to significantly different positive and normative implications than the implications of standard models with complete and frictionless markets. I will illustrate this by giving some examples of issues of interest to macroeconomists and policymakers. Consumption and Saving The behavior of individual as well as aggregate consumption and saving has been an important research topic for macroeconomists. With complete insurance markets, individuals can fully insure idiosyncratic variations in their earnings. Therefore, individual consumptions will not respond to individual-specific shocks to earnings, but only to aggregate shocks which affect per capita consumption. In fact, individual consumptions will be perfectly correlated with each other and with per capita consumption, and each individual’s consumption will vary as much as anyone else’s and as much as per capita consumption. There is a wealth of empirical evidence strongly at variance with these implications and suggesting that individuals’ consumption and saving behavior is strongly influenced by the uncertainty they face due to the inability to fully insure earning fluctuations. Friedman’s (1957) permanent income theory of conumption was the first attempt to explain the dependence of an individual’s consumption on the individual’s earnings when the opportunity exists to save and dissave at a constant interest rate. Implicit in this formulation is the view that this individual is part of an economy composed of a large number of such individuals whose earnings fluctuate randomly in an idiosyncratic fashion (that is, uncorrelated across individuals) and that insurance markets in which individuals could have fully insured away their earning fluctuations are absent. 2 If the utility function is quadratic, consumption is not restricted to be nonnegative, and the interest rate equals the utility discount rate (Sargent 1987, chap. 12), then it can be shown that consumption in any period equals the consumer’s permanent income, that is, the annuity value of the consumer’s wealth. Therefore, consumption responds strongly to permanent changes in earnings and only weakly to temporary changes in earnings. Further, consumption responds only to previously unanticipated news about permanent income, so changes in consumption from one period to the next are unforecastable. A key feature of the permanent income theory of consumption iscertainty equivalence —that is, the idea that the consumer’s behavior depends only on the conditional expectation of future earnings, not on any other features of the distribution of earnings. 3 Leland (1968), Sandmo (1970), and Dreze and Modigliani (1972) were among the first to analyze the dependence of the individual’s consumption/saving choice on the riskiness in future income. In the context of a two-period problem, they show that whether the person consumes less and saves more or consumes more and saves less in response to riskier future earnings depends on the third derivative of the utility function. If the third derivative is positive—that is, the marginal utility of consumption is convex—then an increase in the riskiness of future earnings causes the consumer to consume less and save more. This extra saving reflects the desire of consumers to protect themselves against low future earnings and has been termed pr cautionary saving. 4 Both the permanent income theory and the theory of precautionary saving ignore liquidity constraints by permitting consumption to be negative. Yet casual evidence suggests that many consumers are constrained in their borrowing and that this affects their consumption behavior in a way different from the predictions of the theories of permanent income or precautionary saving. If consumption has to be nonnegative and individuals face uncertainty in their future earnings (due to incomplete insurance markets), then individuals will be subject to borrowing constraints. This happens because, if their debt is too high, then there is some chance that they may have to default in the event that their future earnings remain unexpectedly low for a number of periods. Therefore, individuals will face binding constraints in how much they can borrow. The presence of borrowing constraints has a significant effect on individual consumption behavior. When an individual’s assets get too low and the individual cannot borrow, that person’s consumption responds strongly to even temporary changes in earnings. However, when assets are high and the individual is a saver rather than a borrower, the person’s consumption responds only weakly to temporary changes in earnings. 5 This kind of behavior at the individual level can have repercussions at the aggregate level as well. When a significant fraction of households are close to being borrowing-constrained, a bad aggregate shock can cause these households to cut back significantly on consumption spending. Consequently, under some conditions, aggregate consumption may respond rather strongly to certain types of aggregate shocks relative to the predictions of a model with complete insurance markets or one without borrowing constraints. At the aggregate level, the combination of a precaut