New Keynesian Economics with Household and Firm Heterogeneity

The Heterogeneous-Agent New Keynesian literature has revisited the transmission of monetary and fiscal policy to consumption using models where heterogeneous households face idiosyncratic income risk and borrowing constraints. We show that the key lessons from this literature also apply to investment using a model where heterogeneous firms face idiosyncratic productivity risk and financial frictions: constrained firms’ investment depends on their free cash flow, generating indirect effects of monetary policy and implying that transfer payments stimulate investment demand. Quantitatively, the strength of these new mechanisms is governed by firms’ marginal propensities to invest (MPIs), similar to the role of marginal propensities to consume (MPCs) for households. But unlike MPCs, we currently lack quasi-experimental evidence about MPIs that we can use to directly discipline the new mechanisms.