DP13775 Resolving New Keynesian Anomalies with Wealth in the Utility Function

Author(s): Pascal Michaillat, Emmanuel Saez
Publication Date: June 2019
Keyword(s):
JEL(s): E32, E52, E62
Programme Areas: Monetary Economics and Fluctuations
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=13775

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.