DP8039 Labor-Market Heterogeneity, Aggregation, and the Lucas Critique

Author(s): Yongsung Chang, Frank Schorfheide
Publication Date: October 2010
Keyword(s): Aggregation, Fiscal Policy, Heterogeneous Agents Economy, Lucas Critique, Representative Agent Model
JEL(s): C11, C32, E32, E62
Programme Areas: International Macroeconomics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=8039

This paper assesses biases in policy predictions due to the lack of invariance of ``structural'' parameters in representative-agent models. We simulate data under various fiscal policy regimes from a heterogeneous-agents economy with incomplete asset markets and indivisible labor supply. Imperfect aggregation manifests itself through preference shocks in the estimated representative-agent model. Preference and technology parameter estimates are not invariant with respect to policy changes. As a result, the bias in the representative-agent model's policy predictions is large compared to the length of predictive intervals that reflect parameter uncertainty.