The New Keynesian model makes several anomalous predictions at the zero lower bound : collapse of output and inflation , and implausibly large effects of forward guidance and government spending . To resolve these anomalies, we introduce wealth into the utility function . The justification is that wealth is a marker of social status, and people value social status. Since people save not only for future consumption but also to accrue social status, the Euler equation is modified. As a result, when the marginal utility of wealth is sufficiently large, the dynamical system representing the equilibrium at the zero lower bound becomes a source instead of a saddle---which resolves all the anomalies.
At the zero lower bound , the New Keynesian model predicts that output and inflation collapse to implausibly low levels, and that government spending and forward guidance have implausibly large effects . To resolve these anomalies, we introduce wealth into the utility function ; the justification is that wealth is a marker of social status, and people value social status. Since people save not only for future consumption but also to accrue social status, the Euler equation is modified. As a result, when the marginal utility of wealth is sufficiently large, the dynamical system representing the equilibrium at the zero lower bound transforms from a saddle to a source---which resolves all the anomalies.
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