Business Cycle Dynamics of a New Keynesian Overlapping Generations Model with Progressive Income Taxation



is consistent with real business cycle models that incorporate habit persistence and
investment adjustment costs. Our model points to the heterogeneity of workers.
2

Our study also confirms the findings of Castaneda et al. (1998), even though our model
emphasizes different channels of transmission for the productivity shock. In the Wal-
rasian economy of the model by Castaneda et al. (1998), a productivity shock affects
the factor prices and, hence, the income distribution. This effect is also present in our
model. In addition, we model progressive income taxation and firms’ profits. There-
fore, a productivity shock also affects government taxes and transfers to the households.
These effects, of course, overlap the standard factor price effects. We find that the dis-
tribution effect of a productivity shock in our model is similar to the one in Castanneda
et al. (1998). In particular, the distribution of income becomes more equal after a
positive productivity shock.

We further apply our model to study the fundamental question how monetary policy
affects the distribution of income and wealth. Quite recently, this relationship has
received renewed interest. Easterly and Fischer (2001) as well as Romer and Romer
(1998) point out in their empirical analysis that inflation hurts the very poor. Galli and
van der Hoeven (2001) provide a survey of the empirical literature. Moreover, there
have been a few initial quantitative studies of the distributional effects of inflation that
are based on general equilibrium models. These include studies by Erosa and Ventura
(2002) and Heer and Siissmuth (2006) who focus on the effects of a change in the
long-run inflation rate and, therefore, perform a comparative steady-state analysis of
the endogenous wealth distributions. In both articles, a rise in the anticipated long-
run inflation rate results in a rise of the wealth inequality. Erosa and Ventura (2002)
emphasize the inflation’s effect on the composition of the consumption good bundle.
Higher inflation results in an increase of the consumption of the credit good at the
expense of the consumption of the cash good, and richer agents have lower credit costs.
Heer and Suissmuth (2006) model the observation that not all agents have access to
the stock market and, therefore, poorer agents are less likely to hold assets whose real
return is not reduced through higher inflation. All these studies, however, refrain from
modelling the effects of unanticipated inflation.

In order to model the short-run effects of monetary policy, we assume that prices
2Christiano, Eichenbaum, and Vigfusson (2003) argue that the negative response of hours depends
on the treatment of hours as a difference stationary process. Modelling hours as a stationary process
they find that per capita hours increase in response to a technology shock.



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