Imperfect Risk Sharing and the Business Cycle.

This article examines the macroeconomic effects of imperfect risk sharing in a class of New Keynesian models with heterogeneous households, demonstrating that such economies can be equivalently represented by a representative-agent (RA) model with two key wedges: a discount factor wedge reflecting consumption risk-sharing failures and a labor supply wedge capturing compositional changes in labor productivity. Using U.S. household-level data from 1992 to 2017, the authors measure these wedges and find that imperfect risk sharing accounts for only about 7% of output volatility on average but plays a significant role during episodes when nominal interest rates hit the zero lower bound, notably contributing to the depth and persistence of the Great Recession. The analysis highlights that the rise in the discount factor wedge during the Great Recession was driven primarily by increased consumption volatility among financially unconstrained households, linked more to a deterioration in risk-sharing mechanisms than to increased income volatility. The study provides a methodology to quantify the aggregate implications of household heterogeneity and incomplete markets, offering empirical targets for future heterogeneous-agent macroeconomic modeling.