Approximate aggregation in the neoclassical growth model with ideosyncratic shocks

Abstract

We provide an explicit aggregation in the neoclassical growth model with aggregate shocks and uninsurable employment risk. We show there are two restrictions on the unemployment shock for approximate aggregation to occur. First the probability of unemployment must be positive for each agent in each time period. That ensures a strong precautionary savings motive. Second, we must have like agents having similar future prospects. That is agents with similar employment status and wealth must have similar employment paths. The solution of the model must have distribution of wealth as a state variable and hence the curse of dimensionality must be confronted. We sidestep this thorny issue by introducing a Walrassian auctioneer that communicates the optimal amount of invested in every period for every outcome of the shocks to the agents.