Jonathan Heathcote

Monetary Advisor

heathcote@minneapolisfed.org
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Jonathan Heathcote is a monetary advisor in the Research Department of the Federal Reserve Bank of Minneapolis. Between 2006 and 2008 he was an economist in the International Finance Division of the Federal Reserve Board of Governors. From 2002 to 2008 he was an assistant and then associate professor at Georgetown University. Jonathan has also taught at the Stockholm School of Economics and Duke University, and the Stern School of Business, New York University. Jonathan received a B.A. in philosophy, politics, and economics from Keble College, Oxford University, in 1993, and his Ph.D. in economics from the University of Pennsylvania in 1998. His work has appeared in several prestigious publications, including the American Economic Review, the Journal of Political Economy, and the Review of Economic Studies. He is currently an editor of the Review of Economic Dynamics.

The Macroeconomics of the Quiet Revolution: Understanding the Implications of the Rise in Women’s Participation or Economic Growth and Inequality

We study the impact of the rise in female labor supply on the economic performance of the United States over the period 1967-2002 through the lens of a calibrated structural model. The model features all the key forces behind the increase in female participation (the “Quiet Revolution”): 1) the decline in marriage rates, 2) the narrowing gender wage gap, 3) the preference (or cultural) shift towards market work, and 4) the change in women’s bargaining power within the household. We find that preference shifts and the rise in relative wages of women were the most important driving forces behind rising women’s participation, while changes in marriage patterns have also had a sizeable effect. We conclude that half of the growth in US earnings per capita over this period can be traced to growth in female labor supply. We also find that the rise in female labor supply has had offsetting effects on income inequality and, therefore, its overall role has been negligible relative to skill-biased demand shifts and rising residual wage volatility.

On the Desirability of Capital Controls

In a standard two-country international macro model, we ask whether imposing restrictions on international non contingent borrowing and lending is ever desirable. The answer is yes. If one country imposes capital controls unilaterally, it can generate favorable changes in the dynamics of equilibrium interest rates and the terms of trade, and thereby benefit at the expense of its trading partner. If both countries simultaneously impose capital controls, the welfare effects are ambiguous. We identify calibrations in which symmetric capital controls improve terms of trade insurance against country-specific shocks and thereby increase welfare for both countries.

Assessing International Efficiency

This chapter is structured in three parts. The first part outlines the methodological steps, involving both theoretical and empirical work, for assessing whether an observed allocation of resources across countries is efficient. The second part applies the methodology to the long-run allocation of capital and consumption in a large cross section of countries. We find that countries that grow faster in the long run also tend to save more both domestically and internationally. These facts suggest that either the long-run allocation of resources across countries is inefficient, or that there is a systematic relation between fast growth and preference for delayed consumption. The third part applies the methodology to the allocation of resources across developed countries at the business cycle frequency. Here we discuss how evidence on international quantity comovement, exchange rates, asset prices, and international portfolio holdings can be used to assess efficiency. Overall, quantities and portfolios appear consistent with efficiency, while evidence from prices is difficult to interpret using standard models. The welfare costs associated with an inefficient allocation of resources over the business cycle can be significant if shocks to relative country permanent income are large. In those cases partial financial liberalization can lower welfare.

Consumption and Labor Supply with Partial Insurance: An Analytical Framework

We develop a model with partial insurance against idiosyncratic wage shocks to quantify risk sharing. Closed-form solutions are obtained for equilibrium allocations and for moments of the joint distribution of consumption, hours, and wages. We prove identification and demonstrate how labor supply data are informative about risk sharing. The model, estimated with US data over the period 1967–2006, implies that (i) 39 percent of permanent wage shocks pass through to consumption; (ii) the share of wage risk insured increased until the early 1980s; and (iii) preference heterogeneity is important in accounting for observed dispersion in consumption and hours.

The International Diversification Puzzle Is Not as Bad as You Think

The international diversification puzzle is the fact that country portfolios are on average biased toward domestic assets, while one-good international macro models with nondiversifiable labor income risk predict the opposite pattern of diversification. This paper embeds a portfolio choice decision in a two-good international business cycle model and provides a closed-form solution for equilibrium country portfolios. Equilibrium portfolios are biased toward domestic assets because endogenous international relative price fluctuations make domestic assets a good hedge against labor income risk. Evidence from developed economies in recent years is qualitatively and quantitatively consistent with the mechanisms highlighted by the theory.

From Wages to Welfare: Decomposing Gains and Losses from Rising Inequality

This paper offers a critical evaluation of the large literature that studies the welfare consequences of the recent shift in the wage structure in the United States. Welfare calculations based on changes in the empirical distributions of consumption and hours worked –analyzed through the lens of a social welfare function – yield welfare losses on the order of two percent of lifetime consumption. However, two key components of the shift in the wage structure – the growth in the skill premium and the rise in wage volatility – can potentially generate welfare gains as individuals adjust their education and labor supply decisions. Quantifying the importance of these channels of adjustment requires a structural model. In our model-based calculations, under a plausible calibration, we find welfare gains exceeding one percent of lifetime consumption.

The Macroeconomic Implications of Rising Wage Inequality in the United States

In recent decades, American workers have faced a rising college premium, a narrowing gender gap, and increasing wage volatility. This paper explores the quantitative and welfare implications of these changes. The framework is an incomplete-markets life cycle model in which individuals choose education, intrafamily time allocation, and savings. Given the observed history of the U.S. wage structure, the model replicates key trends in cross-sectional inequality in hours worked, earnings, and consumption. Recent cohorts enjoy welfare gains, on average, as higher relative wages for college graduates and for women translate into higher educational attainment and a more even division of labor within the household.

Unequal We Stand: An Empirical Analysis of Economic Inequality in the United States, 1967–2006

We conduct a systematic empirical study of cross-sectional inequality in the United States, integrating data from the Current Population Survey, the Panel Study of Income Dynamics, the Consumer Expenditure Survey, and the Survey of Consumer Finances. In order to understand how different dimensions of inequality are related via choices, markets, and institutions, we follow the mapping suggested by the household budget constraint from individual wages to individual earnings, to household earnings, to disposable income, and, ultimately, to consumption and wealth. We document a continuous and sizable increase in wage inequality over the sample period. Changes in the distribution of hours worked sharpen the rise in earnings inequality before 1982, but mitigate its increase thereafter. Taxes and transfers compress the level of income inequality, especially at the bottom of the distribution, but have little effect on the overall trend. Finally, access to financial markets has limited both the level and growth of consumption inequality.

Dollarization and Financial Integration

How does a country’s exchange rate regime impact its ability to borrow from abroad? We build a small open economy model in which the government responds to shocks by adjusting monetary policy and foreign borrowing. Sovereign borrowing is subject to endogenous limits, which ensure repayment when the default punishment corresponds to financial autarky. Dollarizing implies renouncing monetary policy, but can make access to international debt markets more valuable, thereby loosening borrowing constraints. This mechanism linking dollarization to financial integration is consistent with observed declines in spreads on foreign-currency debt in countries adopting the dollar or the euro.

Quantitative Macroeconomics with Heterogeneous Households

Macroeconomics is evolving from the study of aggregate dynamics to the study of the dynamics of the entire equilibrium distribution of allocations across individual economic actors. This article reviews the quantitative macroeconomic literature that focuses on household heterogeneity, with a special emphasis on the “standard” incomplete markets model. We organize the vast literature according to three themes that are central to understanding how inequality matters for macroeconomics. First, what are the most important sources of individual risk and cross-sectional heterogeneity? Second, what are individuals’ key channels of insurance? Third, how does idiosyncratic risk interact with aggregate risk?

Insurance and Opportunities: A Welfare Analysis of Labor Market Risk

Using a model with constant relative risk-aversion preferences, endogenous labor supply and partial insurance against idiosyncratic wage risk, this paper provides an analytical characterization of three welfare effects: (a) the welfare effect of a rise in wage dispersion, (b) the welfare gain from completing markets, and (c) the welfare effect from eliminating risk. The analysis reveals an important trade-off for these welfare calculations. On the one hand, higher wage uncertainty increases the cost associated with missing insurance markets. On the other hand, greater wage dispersion presents opportunities to raise aggregate productivity by concentrating market work among more productive workers. Welfare effects can be expressed in terms of the underlying parameters defining preferences and wage risk or, alternatively, in terms of changes in observable second moments of the joint distribution over individual wages, consumption and hours.

The Price and Quantity of Residential Land in the United States

One can conceptualize a house as a bundle comprising a reproducible tangible structure and a non-reproducible plot of land. When the value of a home is decomposed this way, land capitalizes the market value of a home’s location. We develop a formal relationship between the dynamics of house prices, structures costs and land prices, and thereby construct the first constant-quality price and quantity indexes for the aggregate stock of residential land in the United States. In a range of applications we show that these series can shed light on trends, fluctuations and regional variation in the price of housing.

Housing and the Business Cycle

In the United States, the percentage standard deviation of residential investment is more than twice that of nonresidential investment. In addition, GDP, consumption, and both types of investment co-move positively. We reproduce these facts in a calibrated multisector growth model where construction, manufacturing, and services are combined, in different proportions, to produce consumption, business investment, and residential structures. New housing requires land in addition to new structures. The model can also account for important features of industry-level data. In particular, hours and output in all industries are positively correlated, and are most volatile in construction.

Two Views of Inequality Over the Life-Cycle

Data on the life-cycle profiles of inequality in wages, earnings, hours worked, and consumption contain precious information for answering questions about the ability of households to insure labor market risk and about the sources of this risk. This paper demonstrates that the choice of whether to control for cohort effects or for time effects has a drastic impact on the estimated age profiles for inequality and, thus on the answers to those questions. It also shows that time effects are required to account of the observed trends in inequality in 30 years of U.S. data, whereas there is no evidence that cohort effects have been important.

Fiscal Policy with Heterogeneous Agents and Incomplete Markets

I undertake a quantitative investigation into the short run effects of changes in the timing of proportional income taxes for model economies in which heterogeneous households face a borrowing constraint. Temporary tax changes are found to have large real effects. In the benchmark model, a temporary tax cut increases aggregate consumption on impact by around 29 cents for every dollar of tax revenue lost. Comparing the benchmark incomplete-markets model to a complete-markets economy, income tax cuts provide a larger boost to consumption and a smaller investment stimulus when asset markets are incomplete.

Financial Globalization and Real Regionalization

Over the period 1972–1986, the US business cycle was strongly correlated with the business cycle in the rest of the industrialized world. Over the period 1986–2000, international co-movement was much weaker (real regionalization). At the same time, US international asset trade has increased significantly ( financial globalization). We first document these phenomena in detail and then argue that they are related. In particular, we present a model in which financial globalization occurs endogenously in response to less correlated real shocks. Financial globalization, by enhancing cross-border capital flows, further reduces the international correlations in GDP and factor supplies. We find that both less correlated shocks and the endogenous change in international financial markets are needed to quantitatively account for the observed changes in the international business cycle.

On the Distributional Effects of Reducing Capital Taxes

This article asks whether household heterogeneity and market incompleteness have quantitatively important implications for the welfare effects of tax changes. We compare a representative-agent economy to an economy in which households face idiosyncratic uninsurable income risk. The income process is consistent with empirical estimates and implies a realistic wealth distribution. We find that capital tax cuts imply large welfare gains in the representative-agent economy. However, when households are heterogeneous, substantial redistribution during transition means that only a minority will support capital tax cuts, whereas most households can expect large welfare losses.

Why Has the US Economy become Less Correlated with the Rest of the World?

In this paper we do two things. First we document that over the last 40 years the U.S. business cycle has become less synchronized with the cycle in the rest of the world. Second we try to explain why this has happened. We use a general-equilibrium model as a tool to discriminate between two alternative explanations: (i) a change in the nature of real shocks, and (ii) an increase in U.S. financial integration with the rest of the world. Our results indicate that financial integration has played the major role in producing the observed changes in international co-movement.

Financial Autarky and International Real Business Cycles

We present a two-country, two-good model in which there do not exist any markets for international trade in financial assets. We compare the predictions of this model to those of two other models, one in which markets are complete and a second in which a single non-contingent bond is traded. We find that only the financial autarky model can generate volatility in the terms of trade similar to that in data for the floating rate period and, at the same time, account for observed cross-country output, consumption, investment and employment correlations. We interpret our findings as evidence that the extent of international borrowing and lending opportunities is important for the international business cycle.

Optimal Progressivity with Age-Dependent Taxation

This paper studies optimal taxation of labor earnings when the degree of tax progressivity is allowed to vary with age. We analyze this question in a tractable equilibrium overlapping-generations model that incorporates a number of salient trade-offs in tax design. Tax progressivity provides insurance against ex-ante heterogeneity and earnings uncertainty that missing markets fail to deliver. However, taxes distort labor supply and human capital investments. Uninsurable risk cumulates over the life cycle, and thus the welfare gains from income compression via progressive taxation increase with age. On the other hand, average labor productivity rises with age, and thus the welfare losses from progressive taxation’s distortionary impact on labor supply also increase with age. The optimal age-varying system balances these distortions. In a calibrated version of the economy, we quantify the welfare gains of moving from the optimal age-invariant to the optimal age-dependent system and find that they are negligible.

Wealth and Volatility

Between 2007 and 2013, U.S. households experienced a large and persistent decline in net worth. The objective of this paper is to study the business cycle implications of such a decline. We first develop a tractable monetary model in which households face idiosyncratic unemployment risk that they can partially self-insure using savings. A low level of liquid household wealth opens the door to self-fulfilling fluctuations: if wealth-poor households expect high unemployment, they have a strong precautionary incentive to cut spending, which can make the expectation of high unemployment a reality. Monetary policy, because of the zero lower bound, cannot rule out such expectations-driven recessions. In contrast, when wealth is sufficiently high, an aggressive monetary policy can keep the economy at full employment. Finally, we document that during the U.S. Great Recession wealth-poor households increased saving more sharply than richer households, pointing towards the importance of the precautionary channel over this period.

On the Desirability of Capital Controls

In a standard two-country international macro model, we ask whether imposing restrictions on international non contingent borrowing and lending is ever desirable. The answer is yes. If one country imposes capital controls unilaterally, it can generate favorable changes in the dynamics of equilibrium interest rates and the terms of trade, and thereby benefit at the expense of its trading partner. If both countries simultaneously impose capital controls, the welfare effects are ambiguous. We identify calibrations in which symmetric capital controls improve terms of trade insurance against country-specific shocks and thereby increase welfare for both countries.

Optimal Income Taxation: Mirrlees Meets Ramsey

What structure of income taxation maximizes the social benefits of redistribution while minimizing the social harm associated with distorting the allocation of labor input? Many authors have advocated scrapping the current tax system, which redistributes primarily via marginal tax rates that rise with income, and replacing it with a flat tax system, in which marginal tax rates are constant and redistribution is achieved via non-means-tested transfers. In this paper we compare alternative tax systems in an environment with distinct roles for public and private insurance. We evaluate alternative policies using a social welfare function designed to capture the taste for redistribution reflected in the current tax system. In our preferred specification, moving to the optimal flat tax policy reduces welfare, whereas moving to the optimal fully nonlinear Mirrlees policy generates only tiny welfare gains. These findings suggest that proposals for dramatic tax reform should be viewed with caution.

Intergenerational Redistribution in the Great Recession

We construct a stochastic overlapping-generations general equilibrium model in which households are subject to aggregate shocks that affect both wages and asset prices. We use a calibrated version of the model to quantify how the welfare costs of big recessions are distributed across different household age groups. The model predicts that younger cohorts fare better than older cohorts when the equilibrium decline in asset prices is large relative to the decline in wages. Asset price declines hurt the old, who rely on asset sales to finance consumption, but benefit the young, who purchase assets at depressed prices. In our preferred calibration, asset prices decline 2.4 times as much as wages, consistent with the experience of the US economy in the Great Recession. A model recession is close to welfare neutral for households in the 20–29 age group, but translates into a large welfare loss of more than 8% of lifetime consumption for households aged 70 and over.

Optimal Tax Progressivity: An Analytical Framework

What shapes the optimal degree of progressivity of the tax and transfer system? On the one hand, a progressive tax system can counteract inequality in initial conditions and substitute for imperfect private insurance against idiosyncratic earnings risk. At the same time, progressivity reduces incentives to work and to invest in skills, and aggravates the externality associated with valued public expenditures. We develop a tractable equilibrium model that features all of these trade-offs. The analytical expressions we derive for social welfare deliver a transparent understanding of how preferences, technology, and market structure parameters influence the optimal degree of progressivity. A calibration for the U.S. economy indicates that endogenous skill investment, flexible labor supply, and the externality linked to valued government purchases play quantitatively similar roles in limiting desired progressivity.

Assessing International Efficiency

This chapter is structured in three parts. The first part outlines the methodological steps, involving both theoretical and empirical work, for assessing whether an observed allocation of resources across countries is efficient. The second part applies the methodology to the long-run allocation of capital and consumption in a large cross section of countries. We find that countries that grow faster in the long run also tend to save more both domestically and internationally. These facts suggest that either the long-run allocation of resources across countries is inefficient, or that there is a systematic relation between fast growth and preference for delayed consumption. The third part applies the methodology to the allocation of resources across developed countries at the business cycle frequency. Here we discuss how evidence on international quantity comovement, exchange rates, asset prices, and international portfolio holdings can be used to assess efficiency. Overall, quantities and portfolios appear consistent with efficiency, while evidence from prices is difficult to interpret using standard models. The welfare costs associated with an inefficient allocation of resources over the business cycle can be significant if shocks to relative country permanent income are large. In those cases partial financial liberalization can lower welfare.

Consumption and Labor Supply with Partial Insurance: An Analytical Framework

This paper develops a model with partial insurance against idiosyncratic wage shocks to quantify risk sharing, and to decompose inequality into life-cycle shocks versus initial heterogeneity in preferences and productivity. Closed-form solutions are obtained for equilibrium allocations and for moments of the joint distribution of consumption, hours, and wages. We prove identification and estimate the model with data from the CEX and the PSID over the period 1967–2006. We find that (i) 40% of permanent wage shocks pass through to consumption; (ii) the share of wage risk insured privately increased until the early 1980s and remained stable thereafter; (iii) life-cycle productivity shocks account for half of the cross-sectional variance of wages and earnings, but for much less of dispersion in consumption or hours worked.

Intergenerational Redistribution in the Great Recession

In this paper we construct a stochastic overlapping-generations general equilibrium model in which households are subject to aggregate shocks that affect both wages and asset prices. We use a calibrated version of the model to quantify how the welfare costs of severe recessions are distributed across different household age groups. The model predicts that younger cohorts fare better than older cohorts when the equilibrium decline in asset prices is large relative to the decline in wages, as observed in the data. Asset price declines hurt the old, who rely on asset sales to finance consumption, but benefit the young, who purchase assets at depressed prices. In our preferred calibration, asset prices decline more than twice as much as wages, consistent with the experience of the US economy in the Great Recession. A model recession is approximately welfare-neutral for households in the 20–29 age group, but translates into a large welfare loss of around 10% of lifetime consumption for households aged 70 and over.

Unequal We Stand: An Empirical Analysis of Economic Inequality in the United States, 1967–2006

We conduct a systematic empirical study of cross-sectional inequality in the United States, integrating data from the Current Population Survey, the Panel Study of Income Dynamics, the Consumer Expenditure Survey, and the Survey of Consumer Finances. In order to understand how different dimensions of inequality are related via choices, markets, and institutions, we follow the mapping suggested by the household budget constraint from individual wages to individual earnings, to household earnings, to disposable income, and, ultimately, to consumption and wealth. We document a continuous and sizable increase in wage inequality over the sample period. Changes in the distribution of hours worked sharpen the rise in earnings inequality before 1982, but mitigate its increase thereafter. Taxes and transfers compress the level of income inequality, especially at the bottom of the distribution, but have little effect on the overall trend. Finally, access to financial markets has limited both the level and growth of consumption inequality.

Quantitative Macroeconomics with Heterogeneous Households

Macroeconomics is evolving from the study of aggregate dynamics to the study of the dynamics of the entire equilibrium distribution of allocations across individual economic actors. This article reviews the quantitative macroeconomic literature that focuses on household heterogeneity, with a special emphasis on the “standard” incomplete markets model. We organize the vast literature according to three themes that are central to understanding how inequality matters for macroeconomics. First, what are the most important sources of individual risk and cross-sectional heterogeneity? Second, what are individuals’ key channels of insurance? Third, how does idiosyncratic risk interact with aggregate risk?

Discussion of “Heterogeneous Life-Cycle Profiles, Income Risk and Consumption Inequality” by Giorgio Primiceri and Thijs van Rens

The International Diversification Puzzle Is Not as Bad as You Think

In simple one-good international macro models, the presence of non-diversifiable labor income risk means that country portfolios should be heavily biased toward foreign assets. The fact that the opposite pattern of diversification is observed empirically constitutes the international diversification puzzle. We embed a portfolio choice decision in a frictionless two-country, two-good version of the stochastic growth model. In this environment, which is a workhorse for international business cycle research, we derive a closed-form expression for equilibrium country portfolios. These are biased towards domestic assets, as in the data. Home bias arises because endogenous international relative price fluctuations make domestic stocks a good hedge against non-diversifiable labor income risk. We then use our theory to link openness to trade to the level of diversification, and find that it offers a quantitatively compelling account for the patterns of international diversification observed across developed economies in recent years.

Dollarization and Financial Integration

How does a country’s choice of exchange rate regime impact its ability to borrow from abroad? We build a small open economy model in which the government can potentially respond to shocks via domestic monetary policy and by international borrowing. We assume that debt repayment must be incentive compatible when the default punishment is equivalent to permanent exclusion from debt markets. We compare a floating regime to full dollarization.
We find that dollarization is potentially beneficial, even though it means the loss of the monetary instrument, precisely because this loss can strengthen incentives to maintain access to debt markets. Given stronger repayment incentives, more borrowing can be supported, and thus dollarization can increase international financial integration. This prediction of theory is consistent with the experiences of El Salvador and Ecuador, which recently dollarized, as well as with that of highly-indebted countries like Italy which adopted the Euro as part of Economic and Monetary Union: in each case, around the time of regime change, spreads on foreign currency government debt declined substantially.