Individual Risks and the Macroeconomy – IRMAC

We will develop both theoretical and numerical tools to solve positive and optimal policy problems in HANK economies. On the theoretical side, we will develop tractable models with
heterogeneous agents that deliver closed-form solutions (zero-liquidity models; CARA. On the numerical side, we will make use of the continuous-time formulation of the agents’ problems to track the whole distribution of agents’ wealth, delivering considerable accuracy and speed gains.
Further, we will work on the development of new algorithms to solve numerically, with high speed, rich heterogeneous-agent model (that algorithm is based on partitioning the set of agents on the basis of the history of individual shocks they have faced, rather than on the basis of their (steady-state) wealth as in Reiter, 2009). Finally, we will connect our theoretical and numerical exploration to micro data, with
special attention to European household surveys.

To summarize, the purpose of the overall project is to revisit the transmission channel and optimality of a variety of policy instruments, under the assumption that individual risks are
uninsured and households are heterogeneous. These policy tools include:
• conventional monetary policy (i.e., changes in nominal interest rates by the central
bank);
• unconventional monetary policy (i.e., forward guidance about future policy rates;
large-scale asset purchases; money-financed fiscal stimulus; etc.);
• transitory expansions in government spending or reductions in taxes;
• public debt policies (i.e., optimal public debt in the presence of liquidity demand);
• changes in the level, cyclicality and duration of unemployment benefit payments and
short-time work arrangements;
• changes in the level, cyclicality and persistence of tariffs on traded goods.
This is a thriving area of macroeconomics in which several teams are currently competing worldwide. We aim at being one of these teams. We stress that we will pay special attention to the euro area, which is currently facing a number of macroeconomic policy challenges. Indeed, in the euro area monetary policy is centralized but constrained (by the zero lower bound on nominal interest rates), why fiscal policy is decentralized and, overall, non-cooperative. Unemployment insurance is also decentralized, hence with no cross-country risk sharing. Our project will thus help better understand how monetary and fiscal policies should be designed in a context where the institutional features of the euro area may aggravate the lack of insurance across households.

Our project belongs to the fast-growing strand of the macroeconomic literature that combines (i) imperfect insurance against unemployment risk at the household level, which leads to a precautionary motive for savings; and (ii) nominal price rigidities, causing the precautionary motive for saving to destabilize aggregate demand and output. This class of papers, referred to as “HANK models” (for “Heterogeneous-Agents New Keynesian models),
integrate two strands of macroeconomics that had so far remained separated: the “New Keynesian” analysis of the business cycle, centered on aggregate demand fluctuations and their stabilization (Woodford, 2003; Gali, 2015); and the “Heterogeneous Agents” literature, centered on idiosyncratic risk and cross-sectional inequalities among households (Aiyagari, 1994; Krussel and Smith, 1998). Over the past few years, much attention has been devoted to the propagation of aggregate shocks in such economies (e.g., Challe et al., 2017; Kaplan et al., 2018; Gornemann et al., 2016, Ravn and Sterk, 2017, 2019). The current frontier in this paradigm is the study of macroeconomic policy, both from a positive and a normative point of view (Albertini et al., 2019; Auclert, 2019; Bhandari et al., 2018; Bilbiie, 2019; Bilbiie and Ragot, 2017; Challe, 2019; Challe et al., 2020; Mitmann et al., 2019; McKay and Reis, 2019; Nuño and Thomas, 2019). We aim at pushing this frontier theoretically, quantitatively and
numerically. It is a nascent field of the literature and we feel that we can significantly contribute to its development.

Labor income risks, namely unemployent risk and wage risk, are a major concern for many workers, essentially because they are imperfectly insured (that is, insurance markets against idiosyncratic labor-income shocks are “incomplete”). As a result, those risks generate significant ex post inequalities across agents as well as an inefficient precautionary motive for saving, whose instability over the business cycle may greatly amplify economic crises. This source of inequality and aggregate instability is a recurrent phenomenon, and one that is dramatically illustrated by the ongoing worldwide economic collapse. The purpose of the project is to (i) quantify how aggregate shocks are amplified under incomplete markets, (ii) clarify the transmission channels of alternative economic policies in these circumstances; and (iii) design macroeconomic policies (monetary policy, fiscal policy, labor-market policies etc.) capable of optimally stabilizing economic crises in the presence of uninsured labor-income risk.

The project will be composed of two main parts: one that will focus on understanding the transmission mechanisms of aggregate shocks and policies under incomplete markets; and another part that will analyze the optimality of macroeconomic policies (i.e., monetary, fiscal, tax, labor-market policies) in response to aggregate shocks. The focus will be on the way different types of aggregate shocks alter the amount of idiosyncratic risk and rising inequality faced by the households. Given these propagation mechanisms, we will investigate the transmission and the optimality of alternative macro and insurance policies following sharp and brutal declines in economic activity, such as those triggered worldwide by the 2008 financial crisis or the current Covid-19 crisis. Both aspects of the study –the positive one and the normative one–, which will require the development of new models and methods, will be divided into several subprojects involving members of the research team and possibly outside co-authors.

To sum up, the purpose of the overall project is to revisit the transmission channel and optimality of a variety of policy instruments, under the assumption that individual risks are uninsured and households are heterogeneous. These policy tools include:
• conventional monetary policy (i.e., changes in nominal interest rates by the central bank);
• unconventional monetary policy (i.e., forward guidance about future policy rates; large-scale asset purchases; money-financed fiscal stimulus; etc.);
• transitory expansions in government spending or reductions in taxes;
• public debt policies (i.e., optimal public debt in the presence of liquidity demand);
• changes in the level, cyclicality and duration of unemployment benefit payments and short-time work arrangements;
• changes in the level, cyclicality and persistence of tariffs on traded goods.
This is a thriving area of macroeconomics in which several teams are currently competing worldwide. We aim at being one of these teams and would like to rely on the support of ANR to achieve this. We stress that we will pay special attention to the euro area, which is currently facing a number of macroeconomic policy challenges. Indeed, in the euro area monetary policy is centralized but constrained (by the zero lower bound on nominal interest rates), why fiscal policy is decentralized and, overall, non-cooperative. Unemployment insurance is also decentralized, hence with no cross-country risk sharing. Our project will thus help better understand how monetary and fiscal policies should be designed in a context where the institutional features of the euro area may aggravate the lack of insurance across households.