EC 744 Lecture Notes:

Incomplete Markets and Bewley Models

Jianjun Miao
Spring 2009
1 Measurement of Inequality
Data Sources Olivetti, Silverman and Hong (2002)
Measures of Interest
Earnings: labor income before taxes
Income: household income before taxes.
Wealth: all marketable assets
Measures of Concentration Let the sample of size a be given by a
1
, a
2
, ..., a
a
,
where a is the variable of interest.
Coecient of Variation:
c(a) =
cto(a)
a
,
where a is the mean and cto(a) is the standard deviation.
Lorenz Curve: Order a
1
, a
2
, ..., a
a
by size in ascending order, yielding
j
1
, j
2
, ..., j
a
. The Lorenz curve plots ia, i = 1, 2, ...a, against :
i
=
P
i
)=1
j
)

P
a
)=1
j
)
.
Gini Coecient: Two times the area between the Lorenz curve and the
forty ve degree line. It is between zero and one.
Skewness coecient:
P
i
)
i
(a
i
a)
3
cto(a)
3
, where )
i
is the relative
frequency of realization i.
Stylized Facts Read Rodriguez, Diaz-Gimenez, Quadrini and Rios-Rull (2002).
Wealth is the most concentrated, earnings are the second, and the income
is the third.
Wealth is positively correlated with income and earnings, but not strongly.
The movement of households up and down the economic scale is greater
when measured by income than by earnings or wealth
Dierences among these three variables among when the data are disag-
gregated by age, employment status, education, and marital status
The poorest 40% of the population holds a very small amount of wealth
(about 2% of total wealth)
The top 1% holds 30% of total wealth while the top quintile holds almost
80%
Then Gini Index is larger than .78.
2 Markov Chain
Markov chain a
t

o
t=0
with state space S = c
1
, c
2
, ..., c
a

Markov (transition or stochastic) matrix 1 =

1
i)

where
1
i)
= Pr

a
t+1
= c
)
[a
t
= c
i

.
Initial probabilities
0
with
0i
= Pr (a
0
= c
i
) .
A set 1 S is called an ergodic set if 1 (c
i
, 1) = 1 for all c
i
1 and
if no proper subset of 1 has this property.
Can compute
Pr

a
t+2
= c
)
[a
t
= c
i

=
a
X
I=1
1
iI
1
I)
Unconditional distributions of a
t

t
1
= Pr (a
1
) =
t
0
1,

t
2
= Pr (a
2
) =
t
0
1
2
,
...

t
I
= Pr (a
I
) =
t
0
1
I
,
where
t
t
= Pr (a
t
)
2.1 Stationary Distribution
Unconditional distributions evolve according to

t
t+1
=
t
t
1
An unconditional distribution is called stationary or invariant if it satises

t
=
t
1
Does
t
converge to ? If yes, and the limit does not depend the initial
distribution
0
, we say the process is asymptotically stationary.
Theorem. Let 1 be a transition matrix with 1
i)
0 for all i, ). Then 1 has
a unique stationary distribution, and the process is asymptotically stationary.
Mean of the stationary distribution
i
1

[a
t
] = j =
a
X
i=1
c
i

i
.
Variance
\ ov

(a
t
) = ov =
a
X
i=1

i
(c
i
j)
2
First-order auto-covariance of the markov chain
Cc (a
t
, a
t1
) =
a
X
i=1

i
a
X
)=1
1
i)
(c
i
j)

c
)
j

.
Exercise Consider a Markov chain with state space c, c and transition
"
j 1 j
1 j j
#
.
Compute its stationary mean, variance and autocorrelation.
3 A Consumption/Savings Problem
Consumption/Savings Problem:
1
2
4
o
X
t=0
o
t
l(c
t
)
3
5
,
subject to
c
t
+o
t+1
= (1 +v)o
t
+&c
t
, o
0
given,
where o (1 +v) < 1.
Borrowing constraint:
o
t+1
o.
DP
(o, c) = max
o
t
o
l((1 +v)o +&c o
t
) +o
Z
(o
t
, c
t
)Q(c, oc
t
)
Policy function o
t
= j (o, c)
Example. Ignore the borrowing constraint for now. Solve for the consump-
tion/savings problem explicitly for (i) CRRA utility without labor income; (ii)
CARA utility with labor income
c
t+1
= jc
t
+.
t+1
where .
t
is IID normal.
3.1 Borrowing Limits: Natural and ad hoc
ad hoc borrowing limit o = b.
natural borrowing limit
o =
&c
1
v
.
Example. Analyze the deterministic consumption/savings model with borrow-
ing constraint for the cases of o (1 +v) < 1, o (1 +v) = 1 and o (1 +v)
1. Please consult the textbook.
3.2 Discrete State Space Method
Discretize the state space
, = [o = o
1
< o
2
... < o
a
], S = [c
1
< c
2
< ... < c
n
]
Discretized Bellman equation
(o
I
, c
i
) = max
o
t
,
l((1 +v)o
I
+&c
i
o
t
) +o
n
X
)=1
1
i)
(o
t
, c
)
).
We obtain discretized value function
Ii
= (o
I
, c
i
)
Step 1. Start with = 0 where is an a n matrix
Step 2. Solve for the above maximization problem to obtain decision rule
and updated value function t
Step 3. If [t [ < ., the stop. Otherwise, let = t and go to step 2.
Suppose the decision rule is given by o
t
= j (o, c)
3.3 Asset-Employment Distributions
Let A
t
(o, c) = Pr (o
t
= o, c
t
= c) . Then
A
t+1

o
t
, c
t

=
X
o
X
c
1
o
t
=j(o,c)
Pr

c
t+1
= c
t
[c
t
= c

A
t
(o, c) .
If there is a solution such that A
t
= A
t+1
= A
+
, then A
+
is called a
stationary distribution.
Interpret A
t
as a distribution of agents over individual state variables (o, c)
Does a staionary distribution exist?
3.4 Long Run Behavior
Euler equation
l
t
(c
t
) o (1 +v) 1
t
h
l
t
(c
t+1
)
i
,
with equality if o
t+1
o.
Let A
t
= o
t
(1 +v)
t
l (c
t
) 0. Then
A
t
1
t
[A
t+1
] .
(A
t
) is a nonnegative supermartingale. By the supermartingale conver-
gence theorem, A
t
converges almost surely to a nonnegative r.v A
+
.
If o (1 +v) 1, then l
t
(c
t
) converges to zero almost surely. So c
t
diverges.
What happens when o (1 +v) < 1? For IID case, Aiyagari (1994) proves
the existence of a stationary distribution. For nite 2 state Markov chain,
Huggett (1993) also proves this result.
Challenging Problem. Can you prove this for general Markov processes?
3.5 Average Assets as function of v
For o (1 +v) < 1, 1o (v) is a continuous function of v!
4 Growth Economies: Aiyagari (1994)
4.1 Goals
Study the impact of heterogeneity and aggregation. This is done by build-
ing a version of the Brock and Mirmon (1972) growth model that allows
for a large number of agents, subject to idiosyncratic risk, who cannot
insure perfectly due to incomplete markets.
Quantify the importance of idiosyncratic risk for savings. Many researchers
have conjectured that precautionary savings may account for a signicant
fraction of aggregate savings.
4.2 The Model
Consumers
A continuum of consumers distributed in [0, 1] with Lebesgue measure
Consumers are ex ante identical, but ex post heterogeneous, having ex-
pected utility
1
2
4
o
X
t=0
o
t
l(c
i
t
)
3
5
, l(c) =
c
1
1
1
,
subject to
c
i
t
+o
i
t+1
= (1 +v
t
)o
i
t
+&
t
c
i
t
, o
i
0
given,
Borrowing constraint:
o
i
t+1
o.
Labor endowment is normalized to 1 and c
i
t
is employment (or earnings)
shock, taking values in a compact set S. For each i, (c
i
t
)
t0
is a Markov
process with a common transition function Q(c, oc).
In steady state, v
t
= v, &
t
= &
c
i
t
+o
i
t+1
= (1 +v)o
i
t
+&c
i
t
, o
i
0
given.
Firm
A single rm with CRTS production function
Y = 1(1, .) = 1
c
1
1c
,
FOC
1
1
(1, 1) = v +c, (1)
1
2
(1, 1) = &. (2)
Stationary Equilibrium
Aggregate distribution
A
t
(1) = (i 1 : (o
i
t
, c
i
t
) 1). (3)
Denition. A stationary (competitive) equilibrium (((o
i
t+1
, c
i
t
)
t0
)
i1
, (v, &), A)
consists of an admissible allocation ((o
i
t+1
, c
i
t
)
t0
)
i1
, a system of prices
(v, &) R
2
+
, and a measure A such that: Given &
t
= & and v
t
= v for
all t 0, then
(i) For -a.e. i, (o
i
t+1
, c
i
t
)
t0
solves the consumers problem.
(ii) The rm maximizes prots so that (1) and (2) are satised, where 1
t
=
R
1
o
i
t
(oi), t 0.
(iii) Markets clear, i.e., for all t 0,
Z
1
c
i
t
(oi) = 1, (4)
C
t
+1
t+1
= 1(1
t
, 1) + (1 c)1
t
, (5)
where C
t
=
R
1
c
i
t
(oi).
(iv) The aggregate distribution is invariant and nonrandom, i.e., A
t
= A a.s.,
where A
t
is given by (3), t 0.
Recursive Equilibrium
Dynamic programming problem
(o, c) = max
o
t
o
l((1 +v)o +&c o
t
) +o
Z
(o
t
, c
t
)Q(c, oc
t
)
A recursive stationary (competitive) equilibrium ((\, j), (v, &), A) consists of
a system of constant prices (v, &) R
2
+
, a value function \ : A S R, a
policy function j : A S A, and a probability distribution A T(A S)
such that:
(i) Given prices (v, &), \ and j solve the above DP.
(ii) Given prices (v, &), the rm maximizes prots, i.e., v = 1
1
(1, 1)c, & =
1
2
(1, 1), where 1 =
R
AS
oA(oo, oc).
(iii) Markets clear:
R
AS
cA(oo, oc) = 1.
(iv) A is an invariant distribution, i.e., for all 1 B(A) B(S),
A(1) =
Z
AS
1

(j(o, c))Q(c, 1)A(oo, oc).

Existence Suppose that shocks are i.i.d. Then there is a stationary equi-
librium with o(1 + v
+
) < 1. Moreover, the interest rate in any stationary
equilibrium must satisfy o(1 +v
+
) < 1.
Proof: Step 1. Analyze an individuals income uctuation problem.
Dynamic programming. Blackwell Sucient Theorem. Maximum Theorem.
Step 2. If o(1 + v) < 1, then there is a stationary distribution A(v). (See
Miao, 2001)
There is a compact ergodic set for the joint process (o
t
, c
t
)
t0
.
The policy function j(o, c) is increasing in (o, c)
Use Hopenhayn and Prescott (1986).
Step 3. Properties of aggregate asset supply 1
c
(v) =
R
AS
oA(oo, oc)(v)
and asset demand 1
o
(v).
Step 4. If o(1 +v) 1, then c
t
and o
t
go to innity as t o.
Use the Martingale Convergence Theorem.
Challenging Problem How to deal with the case with Markov shocks? What
are the diculties?
Calibration
Earnings process
log(|
t
) = j log(|
t1
) +o
q
1 j
2
.
t
, .
t
.(0, 1)
Approximate |
t
by a nite Markov chain using Tauchen (1986).
Parameter values
c o j o
1, 3, 5 0.36 0 0, 0.3, 0.6, 0.9 0.2, 0.4
Computation
1. For xed value of v = v
1
, compute 1
o
and & as functions of v from
(1)-(2).
2. Use the optimal policy j(I, c) to deduce an associated stationary distrib-
ution A(o, c) :
A
t+1
(o
t
, c
t
) =
X
o
X
c
1(o
t
, o, c)1
cc
tA
t
(o, c)
where 1(o
t
, o, c) = 1 if o
t
= j(o, c), = 0, otherwise.
1. Compute aggregate asset supply 1
c
(v
1
).
2. Compute the value v
2
such that 1
o
(v
2
) = 1
c
(v
1
). If v
2
exceeds the rate
of time preference, then it is replaced by the rate of time preference.
3. (bisection) Let v
3
= (v
1
+v
2
)2 and go to step 1 to compute 1
c
(v
3
).
4. Let . 0 be a small tolerance level. If 1
c
(v
3
) 1
o
(v
3
) +., then v
2
is
replaced by v
3
and use bisection again. If 1
c
(v
3
) < 1
o
(v
3
) ., then v
1
replaced by v
3
and use bisection again.
5. If

1
c
(v
3
) 1
o
(v
3
)

< ., then stop.

Computation Exercise. Replicate Aiyagari (1994). You can use value func-
tion iteration method or other method such as the projection method, or the
method described in Aiyagari (1994).
4.3 Conclusions
Contribution of idiosyncratic risk to aggregate savings is modest. The
aggregate savings rate increases by no more than 3 percentage points.
Access to asset markets is quite important in smoothing out earnings uc-
tuations. Asset markets allow an individual to cut his consumption vari-
ability by half and enjoy a welfare gain worth about 8% of GNP.
The model is consistent with certain features of the income and wealth
distribution. Particularly, the distributions are positively skewed (median
<mean). Wealth distributions are more unequal than income distributions.
Cannot generate the observed degrees of inequality.
5 Exchange Economies and Monetary Theory
5.1 Pure Credit Economies: Huggett (1993)
A continuum of agents each of whom is subject to idiosyncratic endowment
shocks.
Shocks are governed by a Markov chain with transition matrix 1
Each agent can borrow or lend at a risk-free rate v
There is a borrowing constraint b 0
Denition. A stationary equilibrium is an interest rate v, a policy function
j (o, c) , and a stationary distribution A(o, c) for which
a. The policy function j (o, c) solves the agents savings problem.
b. The stationary distribution A(o, c) is induced by 1 and j (o, c) .
c. The loan markets clear,
X
o,c
A(o, c) j (o, c) = 0.
5.2 Bewleys Basic Model of Fiat Money
Suppose v = 0, b = 0,
c
t
+
n
t+1
j
=
n
t
j
+&c
t
, n
0
given,
Fixed money supply A
Let o
t
= n
t+1
j
Equilibrium condition is
1o (0) =
A
j
What happens if introducing borrowing constraint b 0? The larger is b,
the larger is j.
Inside money substitutes outside money
5.3 A Model of Seigniorage
Budget constraint
c
t
+
n
t+1
j
t
=
n
t
j
t
+&c
t
, n
0
given.
Let o
t+1
= n
t+1
j
t
.
Supply money over time to nance a xed government spending
A
t+1
= A
t
+j
t
G
or
A
t+1
j
t
=
A
t
j
t1
j
t1
j
t
+G
Seek a stationary equilibrium with j
t1
j
t
= 1+v and A
t+1
j
t
= o for
all t
Equilibrium interest rate v < 0; v can be regarded as an ination tax.
An increase in b lowers v. When b is large enough, a stationary equilib-
rium may not exist. This may explain why governments intent on raising
seigniorage might want to restrict private borrowing.
5.4 Friedmans Rule
Can allowing interest on currency improve equilibrium outcome?
Household budget constraint
n
t+1
+j
t
c
t
(1 + e v) n
t
+j
t
&c
t
tj
t
Government budget constraint
A
t+1
= A
t
+ e vA
t
tj
t
Explicit Interest through Fixed Money Supply
Set A
t
= A
t+1
all t and try to support a constant price level. So
t = e vAj
The economy is isomorphic to a pure credit economy with borrowing con-
straint b = Aj, v = e v, and n
t+1
j = o
t+1
+Aj.
The highest interest rate that can be supported by paying interest on
currency equals that associated with the pure credit model with the natural
debt limit.
The Friedmans rule to pay real interest on currency at the rate j 0
cannot be implemented in this model.
Implicit Interest through Ination
Suppose there is no explicity interest on currency (e v = 0). But the govern-
ment can pay interest through deation. What is the equilibrium money
growth?
The government budget constraint
A
t+1
= A
t
tj
t
, A
t+1
= (1 +j) A
t
.
We seek a stationary equilibrium in which j
t1
j
t
= (1 +v) . Then
(1 +v) = (1 +j)
1
and
t =
jA
t
j
t
=
A
t
j
t1
v
The budget constraint becomes
c
t
+
n
t+1
j
t

n
t
j
t1
(1 +v) +&c
t

A
t
j
t1
v
6 Life-Cycle Model: Huggett (1996)
6.1 Goals
Investigate age-wealth distribution at a quantitative level. This is done by
building a version of the Diamond (1965) growth model that allows for (i) a large
number of nitely-lived agents, (ii) earnings, health and longevity uncertainty,
(iii) institutional features such as social security, income taxation, and social
insurance, (iv) market features such as borrowing constraints and the absence
of some insurance markets.
6.2 The Model
Households
OLG Model
Live for . periods, survival probability c
)
conditional on surviving up to
age ) 1.
Population grows at rate a. Age ) agents make up a constant fraction
j
)
= j
)1
c
)
(1 +a) of the population at any time.
Age 1 agent utility
1
2
4
.
X
)=1
o
)

)
i=1
c
i

&

c
)

3
5
where
&(c) = c
1o
(1 o).
Labor endowment in eciency units is given by c(:, )). : is a Markov
shock taking values in a nite set Z. The transition probability is
DP problem
\ (o, :, )) = max
c,o
t
&(c) +oc
)+1
1
h
\ (o
t
, :
t
, ) + 1)[o, :
i
subject to
c +o
t
= o(1 +v(1 t)) + (1 0 t)c(:, ))& +T +b
)
,
c 0, o
t
o and o
t
0 if ) = ..
Social security benet b
)
= 0 for ) 1, = b for ) 1.
Policy function o
t
= j(o, :, ))
Firm
CRTS:
Y = 1(1, 1) = 1
c
1
1c
.
Capital depreciates at rate c
Equilibrium
State space
A = [o, o] Z
Dene
)
(1) as the fraction of age ) agents whose individual states lie in
1 B(A) as a proportion of all age ) agents.
Age distribution

)
(1) =
Z
A
1(o, :, ) 1, 1)
)1
(oo, o:),
where
1(o, :, ) 1, 1) = Pr

:
t
Z : (j(o, :, )), :
t
) 1[:

.
Denition A stationary equilibrium is (c(o, :, )), j(o, :, )), v, &, 1, T, G, b)
and distribution (
1
,
2
, ...,
.
) such that
1. c(o, :, )) and j(o, :, )) are optimal decision rule.
2. Firm optimizes
& = 1
2
(1, 1), & = 1
1
(1, 1).
3. Markets clear
X
)
j
)
Z
A
(c(a, )) +j(a, ))) o
)
+G = 1 (1, 1) + (1 c) 1,
X
)
j
)
Z
A
j(a, ))o
)
= (1 +a)1,
X
)
j
)
Z
A
c(:, ))o
)
= 1 = 1.
4. Distributions are consistent with individual behavior,

)
(1) =
Z
A
1(o, :, ) 1, 1)
)1
(oo, o:),
5. Government budget constraint:
G = t(v1 +&1).
6. Social security benets equal taxes:
0&1 = b
0
@
.
X
)=1
j
)
1
A
.
7. Transfers equal accidental bequests:
T =
2
4
X
)
j
)
(1 c
)+1
)
Z
A
j(a, ))(1 +v(1 t))o
)
3
5
(1 +a).
Calibration
Parameter values
o o c c . 1 c
t
a t 0 o
1.011 1.5 0.8959 0.36 0.06 56,79 46 * 0.012 * 0.1 0,&
Log labor endowment process
j
t
j
t
= (j
t1
j
t1
) +.
t
, .
t
.(0, o
2
.
).
Let :
t
= j
t
j
t
. Approximate j
t
by 18 states nite Markov chain :
t
,
:
t
= :
t1
+.
t
.
Labor endowment
c(:, t) = c
:
t
+j
t
Computation
Step 1. Choose 1.
Step 2. Set & and v according to equilibrium condition 2.
Step 3. Given & and v, nd j(o, :, t) by solving the DP
Step 4. Calculate the wealth distribution and the new capital stock 1
t
.
Step 5. If 1 is approximately equal to 1
t
, stop. Otherwise adjust 1 and
repeat step 2.
6.3 Conclusions
Can replicate measures of both the aggregate wealth and the transfer
wealth in the US economy
Can produce a number of the features of the distribution of wealth in the
US. E.g., match the US wealth Gini and the fraction of wealth held by the
top 20% of US households.
Cannot generate all of the concentration of wealth in the upper tail of the
distribution.
Cannot explain all of the within-age-group inequality.