Representative Agent Model Research Articles

Rationality, inequality, and the output gap: evidence from a disaggregated Keynesian cross diagram

AbstractThis paper examines the conditions under which a representative agent (RA) model can accurately approximate the output of a multi-agent model that assumes many interacting agents. The study compares the widely used Keynesian cross diagram, which employs a representative agent, to an extended model that explicitly considers multiple interacting households and firms. The extended model reduces to the original RA model when there is one agent of each type. The findings suggest that the RA Keynesian cross diagram model does not accurately approximate the extended multi-agent model when: (1) the network structure of the economy is asymmetric (e.g., firms have different sizes), or (2) the rationality of agents is too low. Additionally, when income inequality is considered by introducing capitalists, the RA model is no longer a good approximation, even if agents are rational. However, fiscal policies that redistribute income can improve the accuracy of the RA model’s predictions. In general, features that increase the overall rationality of the economy and decrease heterogeneity tend to improve the performance of the RA approximation.

Inequality and Asset Prices during Sudden Stops

This paper studies the cross-sectional dimension of Fisher’s debt-deflation mechanism that triggers Sudden Stop crises. Analyzing microdata from Mexico, we show that this dimension has macroeconomic implications that operate via opposing effects. We propose a small open economy, asset-pricing model with heterogeneous-agents and aggregate risk to measure the effects of inequality during crises. In contrast to a representative-agent model, heterogeneity generates persistent current account reversals with smaller drops in asset prices and larger drops in consumption driven by the leveraged households. Moreover, in a lower inequality calibration, we find that crises are less severe, as observed in the data.

A Decomposition of Conditional Risk Premia and Implications for Representative Agent Models

We develop a methodology to decompose the conditional market risk premium and risk premia on higher-order moments of excess market returns into risk premia related to contingent claims on down, up, and moderate market returns. The decomposition exploits information about the risk-neutral market return distribution embedded in option prices, but does not depend on assumptions about the functional form of investor preferences or about the market return distribution. The total market risk premium is highly time-varying, as are the contributions from downside, upside, and central risk. Time-series variation in risk premia associated with each region is primarily driven by variation in risk prices associated with the probability of entering each region at short horizons, but it is primarily driven by variation in risk quantities at longer horizons. Analogous decompositions implied by prominent representative agent models generally fail to match the dynamic risk premium behavior implied by the data. Our results provide a set of new empirical facts regarding the drivers of conditional risk premia and identify new challenges for representative agent models. This paper was accepted by Lukas Schmid, finance. Supplemental Material: The internet appendix and data files are available at https://doi.org/10.1287/mnsc.2022.01663 .

Income and cultural consumption in China: A theoretical analysis and a regional empirical evidence

China's cultural consumption has experienced accelerating growth in the recent decade despite the slowdown of economic growth. This paper analyses the relationship between household income and cultural consumption using a representative agent model. By decomposing consumption into cultural and non-cultural components, we consider an additive utility function that displays a threshold of income above which cultural consumption arises. We also run numerical simulations on the extended model to estimate price and income elasticities of demand for cultural goods and services, and to evaluate the effects of cultural consumption promotion policies through various income and price subsidies which are currently practiced in China.

Optimal climate and fiscal policy in an OLG economy

AbstractThis paper develops a climate–economy model to study the joint design of optimal climate and fiscal policies in economies with overlapping generations (OLGs). I demonstrate how capital taxation, if optimal, drives a wedge between the market costs of carbon (the net present value of marginal damages using the market interest rate) and the Pigouvian tax (the net present value of marginal damages using the consumption discount rate of successive OLGs). In contrast to deterministic infinitely lived representative agent models, at the optimum, the capital income tax is positive, the carbon price equals the market costs of carbon but it falls short of the Pigouvian tax when (i) preferences are not separable over consumption and leisure; and (ii) labor income taxes cannot be age‐dependent. I also show that restrictions on climate change policy provide a novel rationale for positive capital income taxes.

Optimal fiscal policy under capital overaccumulation

AbstractIn a canonical model of heterogeneous agents with precautionary saving motives, Aiyagari [(1995) Journal of Political Economy103(6), 1158–1175.] breaks the classical result of zero capital tax obtained in representative-agent models. Aiyagari argues that with capital overaccumulation the optimal long-run capital tax should be strictly positive in order to achieve aggregate allocative efficiency suggested by the modified golden rule (MGR). In this paper, we find that, depending on the sources of capital overaccumulation, capital taxation may not be the most efficient means to restore the MGR when government debt is feasible. To demonstrate our point, we study optimal policy mix in achieving the socially optimal (MGR) level of aggregate capital stock in an infinite horizon heterogeneous-agents incomplete-markets economy where capital may be overaccumulated for two distinct reasons: (i) precautionary savings and (ii) production externalities. By solving the Ramsey problem analytically along the entire transitional path, we reveal that public debt and capital taxation play very distinct roles in dealing with the overaccumulation problem. The Ramsey planner opts neither to use a capital tax to correct the overaccumulation problem if it is caused solely by precautionary saving—regardless of the feasibility of public debt—nor to use debt (financed by consumption tax) to correct the overaccumulation problem if it is caused solely by production externality (such as pollution)—regardless of the feasibility of a capital tax. The key is that the MGR has two margins: an intratemporal margin pertaining to the marginal product of capital (MPK) and an intertemporal margin pertaining to the time discount rate. To achieve the MGR, the Ramsey planner needs to equate not only the private MPK with the social MPK but also the interest rate with the time discount rate—neither of which is equalized in a competitive equilibrium. Yet public debt and a capital tax are each effective only in calibrating one of the two margins, respectively, but not both.

The Inadequacies of Utility Theory from a Macroeconomic Modelling Perspective

The paper briefly draws on the work of Marx and Keynes to question the contribution that utility theory has made to Macroeconomics. Contemporary utility-theoretic developments (in Growth Theory and Behavioural Economics) are also examined from a Post-Keynesian, Macroeconomic-Modelling perspective and are found to be wanting. First and foremost, we discuss the implications of using representative agent models in a single good (i.e., corn model) context. In these “Robinson-Crusoe” models, the corn uneaten automatically becomes the seed corn planted in the ground and, through her choices, the consumer-farmer-investor implicitly determines the corn's own rate-of-return (interest rate) that ensures optimal production. As such, any departures from full utilisation of capacity and labour can only be the temporary result of optimal though costly processes of adjustment. Macroeconomic behaviour and outcomes that are still not adequately explained by more complex models include: (1) the existence of very high average propensities to save for wealthy households; (2) the phenomenon of liquidity preference, which explains the desire to hold money on the part of investors and determines short-run equilibrium in the market for both real and financial assets while providing a partial explanation for obstructions within the monetary circuit. In this context, it is argued that the process of expectations-formation is best seen as something that is fragile, contingent, and potentially subject to dramatic revision.

The RPEs of RBCs and other DSGEs

In a broad class of non-linear representative agent models, represented by a system of difference equations, we replace rational expectations with linear forecast models conditioning on a predetermined set of regressors. Within this framework, a restricted perceptions equilibrium (RPE) corresponds to a forecast rule that is optimal within that class of models. Local uniqueness of a stationary rational expectations equilibrium (REE) near the non-stochastic steady state is shown to guarantee the existence, uniqueness and E-stability of an RPE local to that steady state. A benchmark RBC model with government spending shocks illustrates the theoretical results.

Belief aggregation for representative agent models

AbstractRepresentative agent models pin down equilibrium asset prices of an underlying heterogeneous agents economy through the utility maximization problem of a representative agent evaluated at aggregate endowment levels. This paper considers a complete markets asset exchange economy in which all economic agents are expected utility maximizers who share the same risk preferences but may have heterogeneous endowments and beliefs. For arbitrary well‐behaved Bernoulli utility functions we derive belief aggregation formulas that characterize the beliefs of an expected utility maximizing representative agent.

Decision-Making under Uncertainty: How Easterners and Westerners Think Differently.

It has long been known that Easterners exhibit more conservative attitudes, cautiousness behaviors, and self-control ability than Westerners; people in Eastern countries show stronger defensive reactions to societal threats than Western people. Are East Asians really risk averters or do some richer underlying preferences drive their behaviors in their decision-making under uncertainty? To answer this question, we examined the risk and ambiguity attitudes of East Asian populations in both gain and loss domains using classical behavioral economic experimental methods. Based on our sample of university students, we found that Easterners are more risk intolerant but more willing to accept ambiguous conditions than their Westerner counterparts in the gain domain. Perhaps surprisingly, Eastern people and Western people have a similar attitude toward risk and ambiguity in the loss domain. The higher level of risk aversion observed among East Asians may be due to the cultural difference between Western countries and Eastern countries. Historically, such risk aversion may make sense, because it would minimize the influence of numerous ecological and historical threats and socio-political practices. Our findings suggest that models that were designed to analyze and predict aggregate behaviors and markets may be ineffective for Eastern populations, and, in the future, it is of significance to develop appropriate representative agent models from the eastern perspective.

Climate policy in an unequal world: Assessing the cost of risk on vulnerable households

Policy makers concerned with setting optimal values for carbon instruments to address climate change externalities often employ integrated assessment models (IAMs). In the past, these tools have relied on representative agent assumptions or other restrictive behaviour and welfare aggregations. However, there is an important trend in the economics of climate change towards including a greater degree of heterogeneity. In the face of global inequality and significant vulnerability of asset poor households, we relax the complete markets assumption and introduce a realistic degree of global household inequality. In contrast to the representative agent framework, we find that a household's position on the global wealth distribution predicts the identity of their most-preferred carbon price. Specifically, poor agents prefer strong public action against climate change to mitigate the risk for which they are implicitly more vulnerable. We find that the carbon tax fills the role of insurance, reducing the volatility of future welfare. It is this role that drives the wedge between rich and poor households’ policy preferences, even in the absence of redistribution. Taking into account the risk channel, we derive an optimal tax value four times larger than standard estimates from representative agent models.

Uninsured idiosyncratic risk and the government asset Laffer curve

We show that uninsured idiosyncratic earnings risk dramatically influences the long-run government asset Laffer curve, that is, the long-run relationship between government assets and the income from them, under zero taxes. In a heterogeneous agent model with uninsured idiosyncratic risk and a borrowing constraint, increasing government assets eventually decreases government asset income to negative values. In contrast, in a standard representative agent model, government asset income increases linearly with government assets. Under the baseline calibration, uninsured idiosyncratic risk reduces the maximum government asset income–output ratio to less than a quarter.

Analysing the behavioural finance impact of 'fake news' phenomena on financial markets: a representative agent model and empirical validation

This paper proposes an original behavioural finance representative agent model, to explain how fake news’ empirical price impacts can persist in finance despite contradicting the efficient-market hypothesis. The model reconciles empirically-observed price overreactions to fake news with empirically-observed price underreactions to real news, and predicts a novel secondary impact of fake news: that fake news in a security amplifies underreactions to subsequent real news for the security. Evaluating the model against a large-sample event study of the 2019 Chinese ADR Delisting Threat fake news and debunking event, this paper finds strong qualitative validation for its model’s dynamics and predictions.

On the welfare effects of phasing out paper currency

We quantify the welfare effects of cash suppression policies within a general equilibrium model where cash reduces transactions costs and aids tax evasion in underground markets. In the model, currency suppression increases transactions costs and raises effective tax rates, but shifts resources out of costly underground markets and relaxes the government budget. When coupled with a reduction in distortionary taxes on consumption or factor inputs to ensure budget neutrality, cash suppression policies increase welfare in our baseline representative agent model. In a model with individual heterogeneity in cash use, suppression increases welfare for all, but by less for cash-intensive users.

Predicting and decomposing why representative agent and heterogeneous agent models sometimes diverge

Heterogeneous agent (HA) and representative agent (RA) models often give very different answers to important economic questions, even when studying the same phenomenon with the otherwise identical assumptions. There are a variety of reasons why HA and RA models may differ. This paper provides a formula that can be used to decompose the different response functions of HA and RA models into six major “mechanical” categories. Because solving HA models is costly, researchers using this formula are better able to predict when an HA model is unlikely to improve upon an RA model, and defend their use of an RA model without first solving the HA model. Moreover, when two models do diverge, this paper provides a framework for understanding mechanically why they diverged.

Information measure for long-range correlated time series: Quantifying horizon dependence in financial markets

Market dynamics is quantified via the cluster entropy S(τ,n)=∑jPj(τ,n)logPj(τ,n), an information measure with Pjτ,n the probability for the clusters, defined by the intersection between the price series and its moving average with window n, to occur with duration τ. The cluster entropy S(τ,n) is estimated over a broad range of temporal horizons M, for raw and sampled highest-frequency data of US markets. A systematic dependence of S(τ,n) on M emerges in agreement with price dynamics and correlation involving short and long range horizon dependence over multiple temporal scales. A comparison with the price dynamics based on Kullback–Leibler entropy simulations with different representative agent models is also reported.

Fiscal Multipliers: A Heterogenous-Agent Perspective

We use an analytically tractable heterogeneous-agent (HANK) version of the standard New Keynesian model to show how the size of fiscal multipliers depends on i) the distribution of factor incomes, and ii) the source of nominal rigidities. With sticky prices but flexible wages, the standard representative-agent (RANK) model predicts large multipliers because profits fall after a fiscal stimulus and the resulting negative income effect makes the representative worker work harder. Our HANK model, where workers do not own stock and thus do not receive profit income, predicts smaller fiscal multipliers. In fact, they are smaller with sticky prices than with flexible prices. When wages are the source of nominal rigidity, in contrast, fiscal multipliers are close to one, independently of income heterogeneity and price stickiness.

Is a Money-financed Fiscal Stimulus Desirable?

We analyse the redistribution channel of a money-financed versus debt-financed fiscal stimulus in a Borrower-Saver frammework. The redistribution channel is larger when we consider a money-financed fiscal stimulus. However, it generates also larger welfare losses than a debt-financed fiscal stimulus, particularly in a borrower-saver framework due to the additional presence of the consumption gap with respect to a representative agent model.

Easing for Whom? Central Bank Asset Purchases and Household Inequlity

Does monetary policy affect household inequality? Does household inequality affect monetary policy transmission? We build a two-agent New Keynesian model with conventional monetary policy and central bank asset purchases to quantitatively address these questions. Expansionary shocks to conventional policy and asset purchases amplify responses of output relative to a representative agent model. Expansionary shocks to conventional policy reduce inequality, while the effect of increased asset purchases on inequality is ambiguous. Expansionary purchases are more likely to increase inequality when those purchases are very persistent or when the central bank follows a strict inflation target. On the other hand, expansionary purchases are more likely to reduce inequality when the policy rate is at the zero lower bound.

Investigation of lyophilized formulation susceptible to the ramp rate of shelf temperature in the primary drying process

In a series of our studies, we revealed that the ramp rate of shelf temperature in the primary drying process affects final product quality in an aggressive cycle (macroscopic collapse occurs at the slow ramp rate whereas acceptable lyophilized cake appearance is observed at the fast ramp rate). However, the studies were performed by disaccharide-based formulations, and whether the other formulations are susceptible to the ramp rate remained unclear. In the present study, the aqueous solutions of a representative bulking agent (mannitol, glycine, dextran, sucrose, trehalose and lactose) and protein model formulation with different levels of bovine serum albumin were lyophilized at different ramp rates. Macroscopic collapse occurred at the slow ramp cycle in a high concentration of disaccharide solutions, which have a low collapse temperature (Tc), and slow ramp-induced collapse was inhibited as the concentration was decreased. Also, drying failure in the slow ramp cycle was not confirmed in mannitol, glycine and dextran formulations. Furthermore, the slow ramp-induced collapse was inhibited as the concentration of the protein was increased. Thus, the amorphous-based formulation with low Tc containing a large amount of bulking agent was considered to be the formulation susceptible to the ramp rate.