Aggregate Implications of Heterogeneous Households in a Sticky-Price Model

This paper analyzes the role of heterogeneous households in propagating shocks over the business cycle by generalizing a basic sticky-price model to allow for imperfect risk sharing between households that differ in labor incomes. I show that imperfectly insured household consumption distorts household incentive to supply labor hours through an idiosyncratic income effect, which in turn generates strategic complementarities in price setting and thus amplifies business cycle fluctuations. This mechanism diminishes the role of nominal rigidities and makes sticky-price models more consistent with microeconomic evidence on the frequency of price changes.