By Greg Kaplan, Benjamin Moll and Giovanni L. Violante
We revisit the transmission mechanism of monetary policy for household consumption in a Heterogeneous Agent New Keynesian (HANK) model. The model yields empirically realistic distributions of wealth and marginal propensities to consume because of two features: uninsurable income shocks and multiple assets with different degrees of liquidity and different returns. In this environment, the indirect effects of an unexpected cut in interest rates, which operate through a general equilibrium increase in labor demand, far outweigh direct effects such as intertemporal substitution. This finding is in stark contrast to small- and medium-scale Representative Agent New Keynesian (RANK) economies, where the substitution channel drives virtually all of the transmission from interest rates to consumption. Failure of Ricardian equivalence implies that, in HANK models, the fiscal reaction to the monetary expansion is a key determinant of the overall size of the macroeconomic response.
This is an exciting paper that merits highlighting even it has been circulating for a few years. Beyond the interesting results, this paper shows how much we have progressed in modeling. Only a few years ago, the justification of using representative agents was that heterogeneous agents do not really matter for aggregates. And indeed, this was true at the time. But since, both RANK and HANK models have evolved, and now they are able to answer questions where heterogeneity matters. And this paper is the best example of this.