DP12601 | Can Heterogeneity Cure New Keynesian Puzzles?

Publication Date

01/15/2018

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Abstract

Yes - and the paper builds an analytical HANK model to derive the closed-form necessary and sufficient conditions for it (and determinacy properties of Taylor rules). The conditions are that (i) the constrained agents’ income elasticity to aggregate income be smaller than one, and (ii) there is self-insurance against idiosyncratic uncertainty. When (i) fails, there is instead compounding of good news on aggregate demand, aggravating the puzzles - a Catch-22, because this is when HANK models deliver desirable amplification. A Wicksellian rule of price-level targeting solves this, ensuring determinacy and curing the puzzles even in the amplification region of HANK.