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Volume 32 of the NBER Macroeconomics Annual features six theoretical and empirical studies of important issues in contemporary macroeconomics, and a keynote address by former IMF chief economist Olivier Blanchard. In one study, SeHyoun Ahn, Greg Kaplan, Benjamin Moll, Thomas Winberry, and Christian Wolf examine the dynamics of consumption expenditures in non-representative-agent macroeconomic models. In another, John Cochrane asks which macro models most naturally explain the post-financial-crisis macroeconomic environment, which is characterized by the co-existence of low and nonvolatile inflation rates, near-zero short-term interest rates, and an explosion in monetary aggregates. Manuel Adelino, Antoinette Schoar, and Felipe Severino examine the causes of the lending boom that precipitated the recent U.S. financial crisis and Great Recession. Steven Durlauf and Ananth Seshadri investigate whether increases in income inequality cause lower levels of economic mobility and opportunity. Charles Manski explores the formation of expectations, considering the efficacy of directly measuring beliefs through surveys as an alternative to making the assumption of rational expectations. In the final research paper, Efraim Benmelech and Nittai Bergman analyze the sharp declines in debt issuance and the evaporation of market liquidity that coincide with most financial crises. Blanchard’s keynote address discusses which distortions are central to understanding short-run macroeconomic fluctuations.

Publisher: University of Chicago Press JournalsReleased: May 22, 2018ISBN: 9780226577975Format: book

**NBER Board of Directors **

**Relation of the Directors to the Work and Publications of the NBER **

**Editorial **

Martin Eichenbaum and Jonathan A. Parker

**When Inequality Matters for Macro and Macro Matters for Inequality **

SeHyoun Ahn, Greg Kaplan, Benjamin Moll, Thomas Winberry, and Christian Wolf

**Comment **

Christopher D. Carroll and Edmund Crawley

**Comment **

Per Krusell

**Discussion **

**Michelson-Morley, Fisher, and Occam: The Radical Implications of Stable Quiet Inflation at the Zero Bound **

John H. Cochrane

**Comment **

Lawrence J. Christiano

**Comment **

Ricardo Reis

**Discussion **

**Dynamics of Housing Debt in the Recent Boom and Great Recession **

Manuel Adelino, Antoinette Schoar, and Felipe Severino

**Comment **

Erik Hurst

**Comment **

Giovanni L. Violante

**Discussion **

**Understanding the Great Gatsby Curve **

Steven N. Durlauf and Ananth Seshadri

**Comment **

Roland Bénabou

**Discussion **

**Survey Measurement of Probabilistic Macroeconomic Expectations: Progress and Promise **

Charles F. Manski

**Comment **

Andrew Caplin

**Comment **

Lars Peter Hansen

**Discussion **

**Credit Market Freezes **

Efraim Benmelech and Nittai K. Bergman

**Comment **

V.V. Chari

**Comment **

Raghuram Rajan

**Discussion **

**Distortions in Macroeconomics **

Olivier Blanchard

© 2018 by The University of Chicago. All rights reserved.

© 2018 by The University of Chicago. All rights reserved.

**Martin Eichenbaum **

*Northwestern University and NBER *

**Jonathan A. Parker **

*MIT and NBER *

The NBER’s 32nd Annual Conference on Macroeconomics brought together leading scholars to present, discuss, and debate six research papers on central issues in contemporary macroeconomics. In addition, Olivier Blanchard, former Chief Economist at the International Monetary Fund, delivered a thought-provoking talk after dinner on whether current models of macroeconomic fluctuations focus on the central distortions underlying business cycles. Finally, we had a special panel session on the economic implications of changes in financial regulation featuring three experts in this area: Lisa Emsbo-Mattingly, Director of Research in Global Asset Allocation at Fidelity Investments and former President of the National Association for Business Economics; Karen Dynan of Harvard and a former Assistant Secretary for Domestic Policy at the US Treasury Department; and Jeremy Stein of Harvard and former board member at the Board of Governors of the Federal Reserve System. Video recordings of the presentations of the papers, summaries of the papers by the authors, the after-dinner speech, and the lunchtime panel discussion are all accessible on the NBER Annual Conference on Macroeconomics web page (**http://www.nber.org/macroannualconference2017/macroannual2017.html). We hope that these videos make a useful complement to this volume and make the content of the conference more widely accessible. **

This conference volume contains edited versions of the six papers presented at the conference, each followed by two written discussions by leading scholars and a summary of the debates that followed each paper. A final chapter contains a paper by Olivier Blanchard based on his speech at the conference.

The first paper in this year’s volume is a significant methodological step forward in non-representative-agent macroeconomics as well as a contribution to the study of the dynamics of national consumption expenditures. When Inequality Matters for Macro and Macro Matters for Inequality

by SeHyoun Ahn, Greg Kaplan, Benjamin Moll, Thomas Winberry, and Christian Wolf introduces a general methodology for solving macroeconomic models with heterogeneous agents in which the state space includes a high-dimensional distribution. The current approach to the solution of such models is the canonical Krusell and Smith (1998) approach, which approximates this distribution by a few moments and solves for optimal individual behavior when individuals only have information on these moments rather than on the complete distribution. In practice, in nearly all applications, the first moment suffices in the sense that the agent’s welfare gain to using more moments in the information set of its optimization problem is trivial. This (quasi) result, known as quasi aggregation,

is widely used, widely cited, and sometimes misunderstood. While aggregate quantities are largely sufficient for prediction, the dynamics of aggregate quantities are often significantly different from those in the equivalent representative agent economy. And as a result, the response to shocks, and so the effects of policy, may be very different.

The paper presents a novel alternative method for the solution of these models that allows agents’ optimal policy rules to depend on a large number of state variables, such as the distribution of wealth in the economy. The essence of the method is to approximate the evolution of the aggregate economy, including the distribution, as a linear system and use dimension-reduction methods to reduce complexity even further. Together, these two steps make solving for the equilibrium very rapid. In addition, provided the time intervals in the discrete approximation are taken to be small enough,

convergence of the economy back to its steady state from any point is accurately measured (it would be exact in the continuous time limit with a continuous sample path). Accompanying the paper, the authors have made toolboxes available to implement the methods of the paper in general models. One discussant refers to the method as a weapon of mass creation.

While the method is quite rapid even for large dimensional state spaces, it does not yet permit nonlinearized initial responses to any given disturbance (that is, the method relies on certainty equivalence to aggregate shocks).

The paper develops two examples of incomplete markets economies in which individual consumer’s consumption choices are not linear in own wealth. So that the distribution of wealth in the economy is necessary to describe the state of the economy. Applying the paper’s methods, these examples show how, in one case, the presence of heterogeneity significantly alters the dynamics of the economy and how, in the other case, one can track the impact of a macroeconomic shock on the complex distribution of wealth in the economy.

Turning to our next paper, a central feature of the post-financial crisis macroeconomic environment is the coexistence of low, nonvolatile inflation rates, near-zero short-term interest rates, and an explosion in monetary aggregates. John H. Cochrane’s paper, Michelson-Morley, Fisher, and Occam: The Radical Implications of Stable Quiet Inflation at the Zero Bound,

is a provocative treatise that focuses on the questions: What class of macro models most naturally explains these observations and what are the implications for monetary policy? The recent US experience of low levels of inflation along with the explosion of monetary aggregates is evidence inconsistent with canonical monetarism. Dispatching the standard New Keynesian model is harder work. The standard, rational expectations New Keynesian model predicts that under an interest rate peg, the equilibrium is indeterminate and gives rise to the possibility of sunspot volatility. If the recent experience constitutes an interest rate peg, then the fact that inflation was quite smooth is evidence against the standard New Keynesian model. In contrast, the paper argues that the New Keynesian model merged with the fiscal theory of the price level is consistent with these postcrisis facts.

The paper then draws out the implications of the fiscal theory for current monetary policy issues. First, what happens to inflation if central banks raise interest rates? The first-order answer to this question is neo-Fisherian: higher interest rates lead to higher inflation except under very special assumptions. Second, the paper assesses the implications for the stance of monetary policy and the view that monetary policy should be normalized, that is, interest rates should be raised closer to their precrisis levels.

Not surprisingly, the paper led to spirited discussions. The first discussant called into question the premise that low postcrisis interest rates should be thought of as an interest rate peg. The second discussant questioned whether New Keynesian models have difficulty generating a decline in inflation after a policy-induced rise in the nominal interest rate. A lot of discussion also focused on the fiscal theory of the price level more generally, and whether it robustly leads to a determinate price level or accounts for ongoing low inflation rates in the face of a pronounced rise in public debt.

Our third paper turns to the topic of the US financial crisis and Great Recession. Both followed the subprime meltdown, leading the media and many observers to infer that the subprime crisis caused the financial crisis and Great Recession. This paper, Dynamics of Housing Debt in the Recent Boom and Great Recession

by Manuel Adelino, Antoinette Schoar, and Felipe Severino, asks about the deeper causes of this lending boom. Much research has confirmed that the expansion of mortgage borrowing and the rise and collapse in house prices was, if not the main cause of, at least a major propagator and amplifier of the Great Recession. But was the lending boom driven by relaxation of credit provision to low-income and low-credit-score households, or was it instead a widespread expansion of collateralized lending based on ex post incorrect expectations of the value of housing as collateral?

The paper shows that the house price boom, the expansion of mortgage debt, and the following wave of defaults was not a subprime phenomenon. Rather, it was spread across the distribution of incomes and house values in the United States. More specifically, the paper uses detailed microdata on mortgages to show that the evolution of borrowing, subsequent defaults, debt-to-income ratios, and loan-to-value ratios were similar across the income distribution throughout the boom and bust. This paper thus adds to the research of Adelino, Schoar, and Severino (**2016), Foote, Loewenstein, and Willen (2016), Mian and Sufi (2016), and Albanesi, DeGiorgi, and Nosal (2017) that shows that there was no major dislocation of credit and shift in defaults toward low-income households. **

The paper and the written discussions place the evidence from the paper in the context of some of the leading general equilibrium models that have attempted to explain the Great Recession through a housing channel. The evidence in the paper is consistent with the expectations view. But it is also consistent with any theory based on a broad-based expansion in borrowing by US households followed by widespread defaults.

Recent research has documented that the United States and many other countries experienced large increases in income inequality over the past several decades. Further, across countries, those with greater inequality have lower social mobility. This stylized fact is referred to as the Great Gatsby curve. The question tackled by our fourth paper, Understanding the Great Gatsby Curve

by Steven Durlauf and Ananth Seshadri, is: Do increases in inequality cause lower levels of economic mobility or opportunity? The paper brings both a structural model and a battery of empirical evidence to argue that the answer to this question is yes. A significant body of research supports the idea that nonmarket, neighborhood characteristics are important determinants of child outcomes through such channels as education, role models, and social learning.

Good neighborhood characteristics come from high-skill or high income neighbors (through, e.g., taxes). So positive assortative matching can be privately optimal. The paper builds a model in which this positive assortative matching implies that greater income inequality reduces income mobility and so propagates through time. In the model, households select into neighborhoods, neighborhoods are a critical ingredient in the development of skills by children, and, through positive associative matching, greater individual-level inequality leads to more inequality across neighborhoods. A critical assumption is that borrowing constraints prohibit parents from borrowing against their children’s income to increase the quality of the neighborhood they live in to raise their children’s income. Thus, increases in inequality at a point in time increase differences across neighborhoods, which in turn reduces mobility across generations and leads to further increases in inequality. Through this dynamic, the model generates a cross-sectional Great Gatsby curve. But it also provides a worrisome picture of the future. Recent increases in inequality may lead to still larger increases in the future through more unequal distribution of opportunity. The paper also presents evidence regarding the critical elements of the model, including estimating a reduced-form Great Gatsby curve and investigating the role of neighborhood in intergenerational mobility in the United States.

The discussion extends the paper’s analysis of existing evidence. In particular, it notes that greater inequality could lead to greater redistribution. But existing evidence suggests that the reverse is true: greater inequality leads to less redistribution. The discussion also analyzes the empirical analysis and places the theory in the literature using a simplified, unifying model.

Since the rational expectations revolution, macroeconomic research has mainly focused on rational expectations equilibria in which the probability distributions that agents perceive correspond to the actual probability distributions that govern the dynamics of the model economy. Based on revealed preference data alone, beliefs and utility functions are not separately identified. Rational expectations equilibria is an assumption that separates the two. An alternative approach is to consider evidence besides that revealed by behavior. Our fifth paper, Survey Measurement of Probabilistic Macroeconomic Expectations: Progress and Promise

by Charles F. Manski, discusses the history and current state of the direct measurement of beliefs through the use of surveys.

The paper reviews and evaluates the main criticisms of the use of survey expectations. Many issues relate to problems with survey measurement more generally, and on most of these issues, significant progress has been achieved. As an example, the paper discusses in detail survey measures of inflation expectations, which, among survey-based expectation measures, have been used the most for research in macroeconomics. The two main surveys of inflation expectations use two different approaches: questions that ask for point predictions and questions that ask for probabilities of different outcomes to construct more of the distribution. The paper discusses how the different approaches have different implications for what one infers about expected inflation. Even with the progress that has been made, the paper notes several open questions about survey measures, such as whether responses themselves conflate utility and probability.

The paper also analyzes the question of how the data from expectations surveys can be used. Should such data be viewed as informative or taken as literally true? The paper shows that expectations are extremely useful for predicting behavior, but that they are likely measured with significant error so that it is not yet clear how best to incorporate them directly into analysis of choice. Among other topics, the discussions take up this issue and propose building a model of survey response errors to improve inference and modeling based on the survey responses.

The paper concludes by discussing future uses of survey data. The most promising use is probably in the development of structural models of belief formation. In part due to the availability of more survey-based measures of subjective expectations, some recent macroeconomic models deviate from rational expectations and employ alternative models of expectations formation. The paper argues that survey expectations can provide some discipline for these exercises. Without additional data on expectations, beliefs and other aspects of models are not separately identified. In keeping with the centrality of the topic, the paper brought out a lively debate at the conference, much of which is reproduced after the written discussions.

The final paper in the volume, Credit Market Freezes

by Efraim Benmelech and Nittai K. Bergman, analyzes a central feature of financial crises: large declines in debt issuance and the evaporation of market liquidity. The paper’s first contribution is to collect and present data on bond issuance during the period surrounding the 1873, 1929, and 2008–2009 financial crises, and to show that there was a substantial decline in bond issuance during and after the onset of these crises.

The second contribution is to try and discriminate between two different explanations of why credit market liquidity declines so much during financial crises using evidence from the cross section of bonds in each crisis. If credit markets freeze because frictions like asymmetric information and adverse selection in bond markets rise, then bond illiquidity should rise as bond values decline. Alternatively, if the crisis makes beliefs more homogenous, then as the dispersion of beliefs about the common value of a given bond declines, there will be less trading and so less liquidity in the crisis, subject to certain caveats about the distribution of endowments among bond participants. Thus, if credit markets freeze because beliefs about common value become more homogeneous, then bond liquidity should be lower for bonds about which there is more agreement.

The paper finds that measures of illiquidity, like bid-ask spreads, rise the most for bonds whose market value decline the most relative to face value. This finding supports an asymmetric information or adverse-selection-based theory of credit market freezes. Additionally, using different proxies for belief dispersion in markets, the paper finds that illiquidity and dispersion in beliefs both rise during financial crises. This finding is inconsistent with liquidity differences being caused by differences in belief dispersion. The paper concludes with a discussion of the implications of the empirical findings for the efficacy of monetary policy during financial crises.

The first discussant raised questions about whether the empirical findings in the paper provide a convincing test of the particular theory of asymmetric information and adverse selection that the paper emphasizes. The discussion presents an alternative framework with adverse selection and reputation that can account for the paper’s findings; the credit market equilibrium is typically efficient and abrupt collapses in trade volume are not a sign of poorly functioning markets. The second discussant raised the same questions and argued that there are a number of models that have similar predictions and for which the policy implications are quite different. Among other topics, the general discussion considered what evidence could distinguish among different theories of illiquidity spikes during financial crises.

The final chapter in this volume is an edited version of the after-dinner speech by Olivier Blanchard, a longtime MIT faculty member and NBER affiliate, a former editor of the *NBER Macroeconomics Annual*, one of the authors in the inaugural issue, and more recently, chief economist at the International Monetary Fund for seven eventful years that included the US financial crisis and the European sovereign debt crisis. The theme of the talk was that macroeconomic research is far from over. Economic models simplify the real world so that we can understand much of how it works. The most strenuous debates in macroeconomics have always involved *how *we simplify. The after-dinner speech first suggested that the key distortions that we currently focus on in models of business cycles may not be the central ones, and as a result we may need a new core model for economic fluctuations. Second, and more tentatively, the talk proposed a set of ingredients for a new core model.

The talk sets out the intellectual history that has led us to the New Keynesian synthesis that lies behind most models used in academic research and by central banks today, and focuses on the distortions that arise from price stickiness (and monopolistic competition). But there are other distortions, such as those arising from wage stickiness, credit frictions, frictions in the banking sector, and liquidity. There are also now rigorously founded behavioral frictions such as limited attention. These frictions may be as critical as nominal rigidities, or even provide a foundation for nominal rigidities as well as other distortions in the economy. The talk sketches a first pass at the ingredients that Blanchard sees as critical for a new generation of dynamic stochastic general equilibrium models. Like many other after-dinner talks at the Annual Conference on Macroeconomics, Blanchard’s provocative ideas led to a vigorous debate after the talk.

As in previous years, the editors posted and distributed a call for proposals in the spring and summer prior to the conference, and some of the papers in this volume were selected from proposals submitted in response to this call. Other papers are commissioned on central and topical areas in macroeconomics. Both are done in consultation with the advisory board, who we thank for their input and support of both the conference and the published volume.

The authors and the editors would like to take this opportunity to thank Jim Poterba and the National Bureau of Economic Research for their continued support for the *NBER Macroeconomics Annual *and the associated conference. We would also like to thank the NBER conference staff, particularly Rob Shannon, for his continued excellent organization and support. We want to thank the advisory board for their assistance in evaluating papers and suggesting topics. We would also like to thank the NBER Public Information staff, and Charlie Radin in particular, for producing the high-quality multimedia content. Financial assistance from the National Science Foundation is gratefully acknowledged. Daniel Green and Gideon Bornstein provided invaluable help in preparing the summaries of the discussions. And last, but far from least, we are grateful to Helena Fitz-Patrick for her invaluable assistance in editing and publishing the volume.

**Endnote **

For acknowledgments, sources of research support, and disclosure of the authors’ material financial relationships, if any, please see **http://www.nber.org/chapters/c13906.ack. **

**References (also appear in the papers) **

Adelino, Manuel, Antoinette Schoar, and Felipe Severino. 2016. Loan Originations and Defaults in the Mortgage Crisis: The Role of the Middle Class.

*Review of Financial Studies *29 (7): 1635–70.

**First citation in text **

Albanesi, Stefania, Giacamo DeGiorgi, and Jaromic Nosal. 2017. Credit Growth and the Financial Crisis: A New Narrative.

Working paper.

**First citation in text **

Foote, Christopher L., Lara Loewenstein, and Paul S. Willen. 2016. Cross-Sectional Patterns of Mortgage Debt during the Housing Boom: Evidence and Implications.

NBER Working Paper no. 22985, Cambridge, MA.

**First citation in text **

Mian, Atif, and Amir Sufi. 2009. The Consequences of Mortgage Credit Expansion: Evidence from the US Mortgage Default Crisis.

*Quarterly Journal of Economics *124 (4): 1449–96.

———. 2016. Household Debt and Defaults from 2000 to 2010: The Credit Supply View.

Working paper.

**First citation in text **

© 2018 by the National Bureau of Economic Research. All rights reserved.

978-0-226-57766-1/2018/2018-0001$10.00

**SeHyoun Ahn **

*Princeton University *

**Greg Kaplan **

*University of Chicago and NBER *

**Benjamin Moll **

*Princeton University, CEPR, and NBER *

**Thomas Winberry **

*Chicago Booth and NBER *

**Christian Wolf **

*Princeton University *

We develop an efficient and easy to use computational method for solving a wide class of general equilibrium heterogeneous agent models with aggregate shocks together with an open source suite of codes that implement our algorithms in an easy to use toolbox. Our method extends standard linearization techniques and is designed to work in cases when inequality matters for the dynamics of macroeconomic aggregates. We present two applications that analyze a two asset incomplete markets model parameterized to match the distribution of income, wealth, and marginal propensities to consume. First, we show that our model is consistent with two key features of aggregate consumption dynamics that are difficult to match with representative agent models: (1) the sensitivity of aggregate consumption to predictable changes in aggregate income, and (2) the relative smoothness of aggregate consumption. Second, we extend the model to feature capital-skill complementarity and show how factor-specific productivity shocks shape dynamics of income and consumption inequality.

**I. Introduction **

Over the last 30 years, tremendous progress has been made in developing models that reproduce salient features of the rich heterogeneity in income, wealth, and consumption behavior across households that is routinely observed in microdata. These heterogeneous agent models often deliver strikingly different implications of monetary and fiscal policies than do representative agent models, and allow us to study the distributional implications of these policies across households.**¹ In principle, this class of models can therefore incorporate the rich interaction between inequality and the macroeconomy that characterizes our world: on the one hand, inequality shapes macroeconomic aggregates; on the other hand, macroeconomic shocks and policies also affect inequality. **

Despite providing a framework for thinking about these important issues, heterogeneous agent models are not yet part of policymakers’ toolboxes for evaluating the macroeconomic and distributional consequences of their proposed policies. Instead, most quantitative analyses of the macroeconomy, particularly in central banks and other policy institutions, still employ representative agent models. Applied macroeconomists tend to make two excuses for this abstraction. First, they argue that the computational difficulties involved in solving and analyzing heterogeneous agent models render their use intractable, especially compared to the ease with which they can analyze representative agent models using software packages like Dynare. Second, there is a perception among macroeconomists that models that incorporate realistic heterogeneity are unnecessarily complicated because they generate only limited additional explanatory power for aggregate phenomena. Part of this perception stems from the seminal work of Krusell and Smith (**1998), who found that the business cycle properties of aggregates in a baseline heterogeneous agent model are virtually indistinguishable from those in the representative agent counterpart.² **

Our paper’s main message is that both of these excuses are less valid than commonly thought. To this end, we make two contributions. First, we develop an efficient and easy-to-use computational method for solving a wide class of general equilibrium heterogeneous agent macro models with aggregate shocks, thereby invalidating the first excuse. Importantly, our method also applies in environments that violate what Krusell and Smith (**1998) have termed approximate aggregation, that is, that macroeconomic aggregates can be well described using only the mean of the wealth distribution. **

Second, we use the method to analyze the time series behavior of a rich two-asset heterogeneous agent model parameterized to match the distribution of income, wealth, and marginal propensities to consume (MPCs) in the microdata. We show that the model is consistent with two features of the time series of aggregate consumption that have proven to be a challenge for representative agent models: consumption responds to predictable changes in income, but at the same time is substantially less volatile than realized income. We then demonstrate how a quantitatively plausible heterogeneous agent economy such as ours can be useful in understanding the distributional consequences of aggregate shocks, thus paving the way for a complete analysis of the transmission of shocks to inequality. These results invalidate the second excuse: not only does macro matter for inequality, but inequality also matters for macro. We therefore view an important part of the future of macroeconomics as the study of distributions—the representative-agent shortcut may both miss a large part of the story (the distributional implications) and get the small remaining part wrong (the implications for aggregates).

In **Section II, we introduce our computational methodology, which extends standard linearization techniques, routinely used to solve representative agent models, to the heterogeneous agent context.³ For pedagogical reasons, we describe our methods in the context of the Krusell and Smith (1998) model, but the methods are applicable much more broadly. We first solve for the stationary equilibrium of the model without aggregate shocks (but with idiosyncratic shocks) using a global nonlinear approximation. We use the finite difference method of Achdou et al. (2015) but, in principle, other methods can be used as well. This approximation gives a discretized representation of the model’s stationary equilibrium, which includes a nondegenerate distribution of agents over their individual state variables. We then compute a first-order Taylor expansion of the discretized model with aggregate shocks around the stationary equilibrium. This results in a large, but linear, system of stochastic differential equations, which we solve using standard solution techniques. Although our solution method relies on linearization with respect to the economy’s aggregate state variables, it preserves important nonlinearities at the micro level. In particular, the response of macroeconomic aggregates to aggregate shocks may depend on the distribution of households across idiosyncratic states because of heterogeneity in the response to the shock across the distribution. **

Our solution method is both faster and more accurate than existing methods. Of the five solution methods for the Krusell and Smith (**1998) model included in the Journal of Economic Dynamics and Control comparison project (Den Haan 2010), the fastest takes around seven minutes to solve. With the same calibration our model takes around a quarter of a second to solve. The most accurate method in the comparison project has a maximum aggregate policy rule error of 0.16% (Den Haan’s [2010] preferred accuracy metric). With a standard deviation of productivity shocks that is comparable to the Den Haan, Judd, and Julliard (2010) calibration, the maximum aggregate policy rule error using our method is 0.05%. Since our methodology uses a linear approximation with respect to aggregate shocks, the accuracy worsens as the standard deviation of shocks increases.⁴ **

However, the most important advantage of our method is not its speed or accuracy for solving the Krusell and Smith (**1998) model. Rather, it is the potential for solving much larger models in which approximate aggregation does not hold and existing methods are infeasible. An example is the two-asset model of Kaplan, Moll, and Violante (2016), where the presence of three individual state variables renders the resulting linear system so large that it is numerically impossible to solve. In order to be able to handle larger models such as this, in Section III we develop a model-free reduction method to reduce the dimensionality of the system of linear stochastic differential equations that characterizes the equilibrium. Our method generalizes Krusell and Smith’s (1998) insight that only a small subset of the information contained in the cross-sectional distribution of agents across idiosyncratic states is required to accurately forecast the variables that agents need to know in order to solve their decision problems. Krusell and Smith’s (1998) procedure posits a set of moments that capture this information based on economic intuition, and verifies its accuracy ex post using a forecast-error metric; our method instead leverages advances in engineering to allow the computer to identify the necessary information in a completely model-free way.⁵ **

To make these methods as accessible as possible, and to encourage the use of heterogeneous agent models among researchers and policymakers, we are publishing an open-source suite of codes that implement our algorithms in an easy-to-use toolbox.**⁶ Users of the codes provide just two inputs: (1) a function that evaluates the discretized equilibrium conditions, and (2) the solution to the stationary equilibrium without aggregate shocks. Our toolbox then solves for the equilibrium of the corresponding economy with aggregate shocks—linearizes the model, reduces the dimensionality, solves the system of stochastic differential equations, and produces impulse responses.⁷ **

In Sections **V and VI, we use our toolbox to solve a two-asset heterogeneous agent economy inspired by Kaplan and Violante (2014) and Kaplan et al. (2016) in which households can save in liquid and illiquid assets. In equilibrium, illiquid assets earn a higher return than liquid assets because they are subject to a transaction cost. This economy naturally generates wealthy hand-to-mouth households—households who endogenously choose to hold all their wealth as illiquid assets and to set their consumption equal to their disposable income. Such households have high MPCs in line with empirical evidence presented in Johnson, Parker, and Souleles (2006), Parker et al. (2013), and Fagereng, Holm, and Natvik (2016). Because of the two-asset structure and the presence of the wealthy hand-to-mouth, the parameterized model can match key features of the joint distribution of household portfolios and MPCs—properties that one-asset models have difficulty in replicating.⁸ Matching these features of the data leads to a failure of approximate aggregation, which together with the model’s size, render it an ideal setting to illustrate the power of our methods. To the best of our knowledge, this model cannot be solved using any existing methods. **

In our first application (**Sec. V) we show that inequality can matter for macro aggregates. We demonstrate that the response of aggregate consumption to an aggregate productivity shock is larger and more transitory than in either the corresponding representative agent or one-asset heterogeneous agent economies, whereas a shock to productivity growth is substantially smaller and more persistent in the two-asset economy than in either the corresponding representative agent or one-asset heterogeneous agent economies. Matching the wealth distribution, in particular the consumption share of hand-to-mouth households, drives these findings since hand-to-mouth households are limited in their ability to immediately increase consumption in response to higher future income growth, their impact consumption response is weaker, and their lagged consumption response is stronger than the response of non-hand-to-mouth households. An implication of these individual-level consumption dynamics is that the two-asset model outperforms the representative agent models in terms of its ability to match the smoothness and sensitivity of aggregate consumption.⁹ Jointly matching these two features of aggregate consumption dynamics has posed a challenge for many benchmark models in the literature (Campbell and Mankiw 1989, Christiano 1989, and Ludvigson and Michaelides 2001). **

In our second application (**Sec. VI) we show that macro shocks can additionally matter for inequality, resulting in rich interactions between inequality and the macroeconomy. To clearly highlight how quantitatively realistic heterogeneous agent economies such as ours can be useful in understanding the distributional consequences of aggregate shocks, in Section VI we relax the typical assumption in incomplete market models that the cross-sectional distribution of labor income is exogenous. We adopt a nested constant elasticity of substitution (CES) production function with capital-skill complementarity as in Krusell et al. (2000), in which high-skilled workers are more complementary with capital in production than are low-skilled workers. First, we show how a negative shock to the productivity of unskilled labor generates a recession that disproportionately hurts low-skilled workers, thus also leading to an increase in income and consumption inequality. Second, we show how a positive shock to the productivity of capital generates a boom that disproportionately benefits high-skilled workers, thus leading to an increase in income and consumption inequality. The response of aggregate consumption to both of these aggregate shocks differs dramatically from that in the representative agent counterpart, thereby providing a striking counterexample to the main result of Krusell and Smith (1998). These findings illustrate how different aggregate shocks shape the dynamics of inequality and may generate rich interactions between inequality and macroeconomic aggregates. **

**II. Linearizing Heterogeneous Agent Models **

We present our computational method in two steps. First, in this section we describe our approach to linearizing heterogeneous agent models. Second, in **Section III we describe our model-free reduction method for reducing the size of the linearized system. We separate the two steps because the reduction step is only necessary for large models. **

We describe our method in the context of the Krusell and Smith (**1998) model. This model is a natural expository tool because it is well known and substantially simpler than the two-asset model in Section V. As we show in Section V, our method is applicable to a broad class of models. **

**Continuous Time **

We present our method in continuous time. While discrete time poses no conceptual difficulty (in fact, Campbell [**1998], Dotsey, King, and Wolman [1999], Veracierto [2002], and Reiter [2009] originally proposed this general approach in discrete time), working in continuous time has three key numerical advantages that we heavily exploit. **

First, it is easier to capture occasionally binding constraints and inaction in continuous time than in discrete time. For example, the borrowing constraint in the Krusell and Smith (**1998) model below is absorbed into a simple boundary condition on the value function and therefore the first-order condition for consumption holds with equality everywhere in the interior of the state space. Occasionally binding constraints and inaction are often included in heterogeneous agent models in order to match features of microdata. **

Second, first-order conditions characterizing optimal policy functions typically have a simpler structure than in discrete time and can often be solved by hand.

Third, and most importantly in practice, continuous time naturally generates sparsity in the matrices characterizing the model’s equilibrium conditions. Intuitively, continuously moving state variables like wealth only drift an infinitesimal amount in an infinitesimal unit of time, and therefore a typical approximation that discretizes the state space has the feature that households reach only states that directly neighbor the current state. Our two-asset model in **Section V is so large that sparsity is necessary to store and manipulate these matrices.¹⁰ **

*A. Model Description *Environment

There is a continuum of households with fixed mass indexed by *j*∈ [0, 1] who have preferences represented by the expected utility function

where ρ is the rate of time preference and θ is the coefficient of relative risk aversion. At each instant *t*, a household’s idiosyncratic labor productivity is *zjt *∈ {*zL*, *zH*} with *zL *< *zH*. Households switch between the two values for labor productivity according to a Poisson process with arrival rates λ*L *and λ*H*.**. A household with labor productivity zjt earns labor income wtzjt. Markets are incomplete; households can only trade in productive capital ajt subject to the borrowing constraint ajt ≥ 0. **

There is a representative firm that has access to the Cobb-Douglas production function

where *Zt *is (the logarithm of) aggregate productivity, *Kt *is aggregate capital, and *Nt *is aggregate labor. The logarithm of aggregate productivity follows the Ornstein-Uhlenbeck process

where d*Wt *is the innovation to a standard Brownian motion, η is the rate of mean reversion, and σ captures the size of innovations.**¹² **

Equilibrium

In equilibrium, household decisions depend on individual state variables specific to a particular household, and aggregate state variables, which are common to all households. The individual state variables are capital holdings *a *and idiosyncratic labor productivity *z*. The aggregate state variables are aggregate productivity *Zt *and the cross-sectional distribution of households over their individual state variables, *gt*(*a*, *z*).

For notational convenience, we denote the dependence of a given equilibrium object on a particular realization of the aggregate state (*gt*(*a*, *z*), *Zt*) with a subscript *t*. That is, we use time-dependent notation with respect to those aggregate states. In contrast, we use recursive notation with respect to the idiosyncratic states (*a*, *z*). This notation anticipates our solution method that linearizes with respect to the aggregate states but not the idiosyncratic states.**¹³ An equilibrium of the model is characterized by the following equations: **

Here *st*(*a*, *z*) = *wtz *+ *rta *− *ct*(*a*, *z*) is the optimal saving policy function corresponding to the household optimization problem **. **

For detailed derivations of these equations, see Achdou et al. (2015). The household’s Hamilton-Jacobi-Bellman equation **denotes the conditional expectation with respect to aggregate states only.¹⁴ The Kolmogorov Forward equation (3) describes the evolution of the distribution over time. The flow change in the mass of households at a given point in the state space is determined by their savings behavior and idiosyncratic productivity shocks. Equation (4) describes the evolution of aggregate productivity. Finally, equations (5), (6), and (7) define prices given the aggregate state. **

We define a *steady state *as an equilibrium with constant aggregate productivity *Zt *= 0 and a time-invariant distribution *g*(*a, z*). The steady-state system is given by

*B. Linearization Procedure *

Our linearization procedure consists of three steps. First, we solve for the steady state of the model without aggregate shocks, but with idiosyncratic shocks. Second, we take a first-order Taylor expansion of the equilibrium conditions around the steady state, yielding a linear system of stochastic differential equations. Third, we solve the linear system using standard techniques. Conceptually, each of these steps is a straightforward extension of standard linearization techniques to the heterogeneous agent context. However, the size of heterogeneous agent models leads to a number of computational challenges which we address.

**Step 1: Approximate Steady State **

Because households face idiosyncratic uncertainty, the steady-state value function varies over individual state variables *v*(*a*, *z*), and there is a nondegenerate stationary distribution of households *g*(*a*, *z*). To numerically approximate these functions we must represent them in a finite-dimensional way. We use a nonlinear approximation in order to retain the rich nonlinearities and heterogeneity at the individual level. In principle, any approximation method can be used in this step; we use the finite difference methods outlined in Achdou et al. (2015) because they are fast, accurate, and robust.

We approximate the value function and distribution over a discretized grid of asset holdings **a **= (*a*1 = 0, *a*2, …, *aI*)T. Denote the value function and distribution along this discrete grid using the vectors **v **= (*v*(*a*1,*zL*), …, *v*(*aI*,*zH*))T and **g **= (*g*(*a*1,*zL*), …, *g*(*aI*,*zH*))T; both **v **and **g **are of dimension *N *× 1 where *N *= 2*I *is the total number of grid points in the individual state space. We solve the steady-state versions of equations **(2) and (3) at each point on this grid, approximating the partial derivatives using finite differences. Achdou et al. (2015) show that if the finite difference approximation is chosen correctly, the discretized steady state is the solution to the following system of matrix equations: **

The first equation is the approximated steady-state HJB equation **(8) for each point on the discretized grid, expressed in our vector notation. The vector u(v) is the maximized utility function over the grid and the matrix multiplication A(v; p)v captures the remaining terms in equation (8). The second equation is the discretized version of the steady-state Kolmogorov Forward equation (9). The transition matrix A(v; p) is simply the transpose of the matrix from the discretized HJB equation because it encodes how households move around the individual state space. Finally, the third equation defines the prices p = (r, w)T as a function of aggregate capital through the distribution g.¹⁵ **

Since **v **and **g **each have *N *entries, the total system has 2*N *+ 2 equations in 2*N *+ 2 unknowns. In simple models like this one, highly accurate solutions can be obtained with as little as *N *= 200 grid points (i.e., *I *= 100 asset grid points together with the two income states); however, in more complicated models, such as the two-asset model in **Section V, N can easily grow into the tens of thousands. Exploiting the sparsity of the transition matrix A(v; p) is necessary to even represent the steady state of such large models. **

**Step 2: Linearize Equilibrium Conditions **

The second step of our method is to compute a first-order Taylor expansion of the model’s discretized equilibrium conditions around steady state. With aggregate shocks, the discretized equilibrium is characterized by

The system **(14) is a nonlinear system of 2 N + 3 stochastic differential equations in 2N + 3 variables (the 2N + 2 variables from the steady state, plus aggregate productivity Zt). Shocks to TFP Zt induce fluctuations in marginal products and therefore prices pt = F(gt; Zt). Fluctuations in prices in turn induce fluctuations in households’ decisions and therefore in vt and the transition matrix A(vt; pt).¹⁶ Fluctuations in the transition matrix then induce fluctuations in the distribution of households gt. **

The key insight is that this large-dimensional system of stochastic differential equations has exactly the same structure as more standard representative agent models that are normally solved by means of linearization methods. To make this point, the "Fully Recursive Formulation of Krussell-Smith (**1998)" section of the appendix relates the system (14) to the real business cycle (RBC) model. The discretized value function points vt are jump variables, like aggregate consumption Ct in the RBC model. The discretized distribution points gt are endogenous state variables, like aggregate capital Kt in the RBC model. TFP Zt is an exogenous state variable. Finally, the wage and real interest rate are statically defined variables, just as in the Krusell and Smith (1998) model. **

As already anticipated, we exploit this analogy and solve the nonlinear system **(14) by linearizing it around the steady state. Since the dimension of the system is large, it is impossible to compute derivatives by hand. We use a recently developed technique called automatic (or algorithmic) differentiation that is fast and accurate up to machine precision. It dominates finite differences in terms of accuracy and symbolic differentiation in terms of speed. Automatic differentiation exploits the fact that the computer represents any function as the composition of various elementary functions such as addition, multiplication, or exponentiation, which have known derivatives. It builds the derivative of the original function by iteratively applying the chain rule. This allows automatic differentiation to exploit the sparsity of the transition matrix A(vt; pt) when taking derivatives, which is essential for numerical feasibility in large models.¹⁷ **

The first-order Taylor expansion of equation **(14) can be written as:¹⁸ **

, *Zt*, are expressed as deviations from their steadystate values, and the matrix is composed of the derivatives of the equilibrium conditions evaluated at steady state. Since the pricing equations are static, the fourth row of this matrix equation only has nonzero entries on the right-hand side.**into the remaining equations of the system, yielding **

**Step 3: Solve Linear System **

The final step of our method is to solve the linear system of stochastic differential equations **(16). Following standard practice, we perform a Schur decomposition of the matrix B and Zt, then we can compute the solution: **

The first line of equation **and Zt, that is, the matrices Dvg and DvZ . **

*C. What Does Linearization Capture and What Does It Lose? *

Our method uses a mix of nonlinear approximation with respect to individual state variables, and linear approximation with respect to aggregate state variables. Concretely, from the first line of equation **(17), the approximated solution for the value function is of the form **

where **D***vg*[*i*, *j*; *k*, *l*] and **D***vZ*[*i*, *j*] denote the relevant elements of **D***vg *and **D***vZ*, and *v*(*a*, *z*) and *g*(*a*, *z*) are the steady-state value function and distribution. Given the value function *vt*(*ai*, *zj*), optimal consumption at different points of the income and wealth distribution is then given by

**Certainty Equivalence **

Expressions **(18) and (19) show that our solution features certainty equivalence with respect to aggregate shocks; the standard deviation σ of aggregate TFP Zt does not enter households’ decision rules.²⁰ This is a generic feature of all linearization techniques. **

However, our solution does *not *feature certainty equivalence with respect to idiosyncratic shocks because the distribution of idiosyncratic shocks enters the HJB equation **(2), as well as its linearized counterpart in equation (16) directly. A corollary of this is that our method does capture the effect of aggregate uncertainty to the extent that aggregate shocks affect the distribution of idiosyncratic shocks. For example, Bloom et al. (2014) and Bayer et al. (2015) study the effect of uncertainty shocks that result in an increase in the dispersion of idiosyncratic shocks and can be captured by our method.²¹ **

Our solution method may instead be less suitable for various asset-pricing applications in which the direct effect of aggregate uncertainty on individual decision rules is key. In future work we hope to encompass such applications by extending our first-order perturbation method to higher orders, or by allowing the decision rules to depend nonlinearly on relevant low-dimensional aggregate state variables (but not the high-dimensional distribution). Yet another strategy could be to assume that individuals are averse to ambiguity so that risk premia survive linearization (Ilut and Schneider **2014). **

**Distributional Dependence of Aggregates **

A common motivation for studying heterogeneous agent models is that the response of macroeconomic aggregates to aggregate shocks may depend on the distribution of idiosyncratic states. For example, different joint distributions of income and wealth *g*(*a*, *z*) can result in different impulse responses of aggregates to the same aggregate shock. Our solution method preserves such *distributional dependence*.

To fix ideas, consider the impulse response of aggregate consumption *Ct *to a productivity shock *Zt*, starting from the steady-state distribution *g*(*a*, *z*). First consider the response of initial aggregate consumption *C*0 only. We compute the impact effect of the shock on the initial value function *v*0(*a*, *z*) and initial consumption *c*0(*a*, *z*) from equations **(18) and (19). Integrate this over households to get aggregate consumption **

The impulse response of *C*0 depends on the initial distribution *g*0(*a*, *z*) because the elasticities of individual consumption *c*0(*a*, *z*) with respect to the aggregate shock *Z*0 are different for individuals with different levels of income and/or wealth. These individual elasticities are then aggregated according to the initial distribution. Therefore, the effect of the shock depends on the initial distribution *g*0(*a*, *z*).

To see this even more clearly, it is useful to briefly work with the continuous rather than discretized value and consumption policy functions. Analogous to equation **where DvZ(a, z) are the elements of DvZ ) by virtue of g where DcZ(a, z) captures the responsiveness of consumption to the aggregate shock.²² The impulse response of initial aggregate consumption is then **

It depends on the steady-state distribution *g*(*a*, *z*) since the responsiveness of individual consumption to the aggregate shock **D***cZ*(*a*, *z*) differs across (*a*, *z*).

**Size and Sign Dependence **

Another question of interest is whether our economy features size or sign dependence, that is, whether it responds nonlinearly to aggregate shocks of different sizes or asymmetrically to positive and negative shocks.**²³ In contrast to state dependence, our linearization method eliminates any potential sign and size dependence. This can again be seen clearly from the impulse response of initial aggregate consumption in equation (20), which is linear in the aggregate shock Z0. This immediately rules out size and sign dependence in the response of aggregate consumption to the aggregate shock.²⁴ **

In future work, we hope to make progress on relaxing this feature of our solution method. Extending our first-order perturbation method to higher orders would again help in this regard. Another idea is to leverage the linear model solution together with parts of the full nonlinear model to simulate the model in a way that preserves these nonlinearities. In particular, one could use the fully nonlinear Kolmogorov Forward equation in **(14) instead of the linearized version in equation (16) to solve for the path of the distribution for times t > 0: dgt / dt = A(vt; pt)Tgt. This procedure allows us to preserve size dependence after the initial impact t > 0 because larger shocks potentially induce nonproportional movements in the individual state space, and therefore different distributional dynamics going forward.²⁵ **

**Small versus Large Aggregate Shocks **

Another generic feature of linearization techniques is that the linearized solution is expected to be a good approximation to the true nonlinear solution for small aggregate shocks and less so for large ones. **Section II.D documents that our approximate dynamics of the distribution is accurate for the typical calibration of TFP shocks in the Krusell and Smith (1998) model, but breaks down for very large shocks.²⁶ **

*D. Performance of Linearization in Krusell-Smith Model *

In order to compare the performance of our method to previous work, we solve the model under the parameterization of the JEDC comparison project (Den Haan et al. **2010). A unit of time is one quarter. We set the rate of time preference ρ = 0.01 and the coefficient of relative risk aversion θ = 1. Capital depreciates at rate δ = 0.025 per quarter and the capital share is α = 0.36. We set the levels of idiosyncratic labor productivity zL and zH following Den Haan et al. (2010). **

One difference between our model and Den Haan et al. (**2010) is that we assume aggregate productivity follows the continuous-time, continuous-state Ornstein-Uhlenbeck process (1) rather than the discrete-time, two-state Markov chain in Den Haan et al. (2010). To remain as consistent with Den Haan et al.’s (2010) calibration as possible, we choose the approximate quarterly persistence corr(log Zt+1, log Zt) = e−η ≈ 1 − η = 0.75 and the volatility of innovations σ = 0.007 to match the standard deviation and autocorrelation of Den Haan et al.’s (2010) two-state process.²⁷ **

In our approximation we set the size of the individual asset grid *I *= 100, ranging from *a*1 = 0 to *aI *= 100. Together with the two values for idiosyncratic productivity, the total number of grid points is *N *= 200 and the total size of the dynamic system **(16) is 400.²⁸ **

**Table 1 shows that our linearization method solves the Krusell and Smith (1998) model in approximately one-quarter of one second. In contrast, the fastest algorithm documented in the comparison project by Den Haan (2010) takes over seven minutes to solve the model—more than 1,500 times slower than our method (see table 2 in Den Haan [2010]).²⁹ In Section III, we solve the model in approximately 0.1 seconds using our model-free reduction method. **

**Accuracy of Linearization **

The key restriction that our method imposes is linearity with respect to the aggregate state variables *Zt *. We evaluate the accuracy of this approximation using the error metric suggested by Den Haan (**2010). The Den Haan error metric compares the dynamics of the aggregate capital stock under two simulations of the model for T = 10,000 periods. The first simulation computes the path of aggregate capital Kt from simulating the model using the nonlinear dynamics (3) as discussed in Section II.C. We then compare the maximum log difference between the two series, **

Den Haan originally proposed this metric to compute the accuracy of the forecasting rule in the Krusell and Smith (**1998) algorithm; in our method, the linearized dynamics of the distribution gt are analogous to the forecasting rule. **

When the standard deviation of productivity shocks is 0.7%, our method gives a maximum percentage error ϵDH = 0.049%, implying that households in our model make small errors in forecasting the distribution. Our method is three times as accurate as the Krusell and Smith (**1998) method, which is the most accurate algorithm in Den Haan (2010), and gives ϵDH = 0.16%. Table 2 shows that, since our method is locally accurate, its accuracy decreases in the size of the shocks σ. However, with the size of aggregate shocks in the baseline calibration, it provides exceptional accuracy. **

**III. Model Reduction **

Solving the linear system **(16) is extremely efficient because the Krusell and Smith (1998) model is relatively small. However, the required matrix decomposition becomes prohibitively expensive in larger models like the two-asset model that we will study in Section V. We must therefore reduce the size of the system to solve these more general models. Furthermore, even in smaller models like Krusell and Smith (1998), model reduction makes likelihood-based estimation feasible by reducing the size of the associated filtering problem.³⁰ **

onto low-dimensional subspaces and solves the resulting low-dimensional system. The main challenge is reducing the

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