Incomplete Markets and Aggregate Demand

42 Pages Posted: 18 Aug 2015

See all articles by Iván Werning

Iván Werning

Massachusetts Institute of Technology (MIT) - Department of Economics; National Bureau of Economic Research (NBER)

Date Written: August 2015

Abstract

I study aggregate consumption dynamics under incomplete markets, focusing on the relationship between consumption and the path for interest rates. I first provide a general aggregation result under extreme illiquidity (no borrowing and no outside assets), deriving a generalized Euler relation involving the real interest rate, current and future aggregate consumption. This provides a tractable way of incorporating incomplete markets in macroeconomic models, dealing only with aggregates. Although this relation does not necessarily coincide with the standard representative-agent Euler equation, I show that it does for an important benchmark specification. When this is the case, idiosyncratic uncertainty and incomplete markets leave their imprint by affecting the discount factor in this representation, but the sensitivity of consumption to current and future interest rates is unaffected. An immediate corollary is that “forward guidance” (lower future interest rates) is as powerful as in representative agent models. I show that the same representation holds with positive liquidity (borrowing and outside assets) when utility is logarithmic. I show that away from these benchmark cases, consumption is likely to become more sensitive to interest rate, and especially future interest rates. Finally, I apply my approach to a real business cycle economy, providing an exact analytical aggregation result that complements existing numerical results.

Suggested Citation

Werning, Ivan, Incomplete Markets and Aggregate Demand (August 2015). NBER Working Paper No. w21448, Available at SSRN: https://ssrn.com/abstract=2645524

Ivan Werning (Contact Author)

Massachusetts Institute of Technology (MIT) - Department of Economics ( email )

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