Precautionary Savings, LifeCycle and Macroeconomics

This paper explores the implications of precautionary saving and life cycle behavior for business cycle fluctuations. Existing heterogenous agent models of the business cycle, with labor income uncertainty and incomplete markets, yield aggregate quantitative predictions that are almost indistinguishable from their representative agent counterpart. This 'quasi' aggregation theorem arises when idiosyncratic shocks are largely transitory. This paper revisits these results in the context of an overlapping generations model with two sources of heterogeneity: age and idiosyncratic shocks to labor income. Surprisingly, even with permanent labor income shocks and finite lives, the previous results are shown to hold: aggregate dynamics are fully characterized by the evolution of the aggregate capital stock. The implications for welfare and risk sharing are derived.