No man is an Island: The impact of heterogeneity and local interactions on macroeconomic dynamics

Abstract

We develop an agent-based model in which heterogeneous firms and households interact in labor and good markets according to centralized or decentralized search and matching protocols. As the model has a deterministic backbone and a full-employment equilibrium, it can be directly compared to Dynamic Stochastic General Equilibrium (DSGE) models. We study the effects of negative productivity shocks by way of impulse-response functions (IRF). Simulation results show that when search and matching are centralized, the economy is always able to return to the full-employment equilibrium and IRFs are similar to those generated by DSGE models. However, when search and matching are local, coordination failures emerge and the economy persistently deviates from full-employment. Moreover, agents display persistent heterogeneity. Our results suggest that macroeconomic models should explicitly account for agents' heterogeneity and direct interactions. Moreover, our results point to the role of quantity adjustments in determining the ability of the economy to return or not to full-employment.