Job market paper. We study how rising permanent labor income (PLI) inequality changes the transmission of monetary and fiscal policy. Standard heterogeneous-agent models imply that hand-to-mouth status is unrelated to permanent income, and that the PLI distribution is therefore neutral. In the PSID, instead, the hand-to-mouth share falls from 64% to 22% across PLI quintiles, a gradient that has steepened since 1999. A model with a non-homothetic taste for wealth reproduces these facts and breaks the neutrality. The incidence of fiscal policy becomes a first-order determinant of the output response: the same deficit stimulates or contracts output depending on who receives and who repays it. For monetary policy, the effect of a rate cut depends on how the government rebates its interest savings.

Submitted. Higher permanent labor income inequality (PLI) raises saving, since households with higher PLI save a larger share of it. For asset markets to clear, prices must adjust: how does this feed back on wealth inequality? If the saving finances capital, interest rates fall, wages rise, and poorer households gain. If it raises asset prices instead, the capital gains accrue to the rich. In a heterogeneous-agent model with non-homothetic wealth preferences and imperfect competition, markups weaken the first channel and let the second dominate for five decades along the transition.

We show that a nonlinear perfect-foresight solution to standard HANK models, computed using standard fast methods, provides a good approximation to the full global solution with aggregate risk, except for a level shift driven by precautionary saving. This result holds in calibrations featuring extensive sign, size, and state dependence in the effects of fiscal policy. We build on, and extend, recent advances in solving heterogeneous-agent models in moving-average (MA) form using deep learning, and confirm the accuracy of this approach.

We introduce a novel deep learning algorithm for solving large life-cycle models with both continuous and discrete choices. This allows us to simultaneously account for both labor supply choices with human capital accumulation, portfolio choices with a risky and a risk-free asset, and housing and mortgage choices. We work directly on the Bellman equation and approximate both value and policy functions with neural networks, and use a simulated training sample instead of tensor product grids. This substantially alleviates the curse of dimensionality. We confirm that we can accurately solve a large life-cycle model in 12 hours on a single GPU. An accompanying easy-to-use software package implements the method.

Despite governments’ commitments to limit global warming to 1.5°C, there is still investment in carbon-intensive capital. This paper uses a growth model featuring irreversible investment, capacity utilisation, clean and polluting capital to study this apparent paradox. It shows that current investment in polluting capital and CO2 emissions are coherent with expectations of a future carbon tax, if investors also expect a bailout of polluting capital. This result implies that governments’ credibility can play an important role in reducing the cost of implementing an optimal carbon tax by committing not to bail out.

Monetary tightening can generate inefficient firm exits, by exacerbating firm illiquidity constraints. Contrary to the common belief that only small firms are affected, new evidence shows that large firms are vulnerable too, leading to large aggregate effects. This paper investigates why monetary tightening causes large firms to exit and explores the macroeconomic implications. To do so, we develop a model of endogenous firm exit with financial frictions and partial irreversibility. The quality of firm selection can therefore endogenously worsen during monetary tightening episodes, highlighting a potential need for support for large firms in distress.