DP12601 A Catch-22 for HANK Models: No Puzzles, No Amplification

Author(s): Florin Ovidiu Bilbiie
Publication Date: January 2018
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Programme Areas: Monetary Economics and Fluctuations
Link to this Page: www.cepr.org/active/publications/discussion_papers/dp.php?dpno=12601

New Keynesian (NK) models with heterogeneous agents (HA) can deliver aggregate-demand amplification (monetary-fiscal multipliers and deep recessions) through a New Keynesian Cross---but only if hand-to-mouth's income elasticity to aggregate is larger than one. This "hand-to-mouth channel" gives static amplification through the within-the-period elasticity of aggregate demand to policies. A dynamic, complementary "self-insurance channel" magnifies the effects when households are hand-to-mouth only occasionally: the aggregate Euler equation features discounting when the elasticity is lower than one, but compounding when larger. The former channel matters most for short-lived shocks, the latter for persistent or future news. Yet amplification has a dark side: the very same condition that delivers it also aggravates the NK troubles (the forward guidance puzzle, neo-Fisherian effects, and the paradox of flexibility) and creates new ones (insufficiency of the Taylor principle and a paradox of thrift). Phrased positively: adding HA can solve all these NK troubles, but that also rules out amplification and multipliers---a Catch-22.