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

Publication Date

23/10/2010

JEL Code(s)

Keyword(s)

Programme Area(s)

Network(s)

Abstract

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.