At the zero lower bound, the New Keynesian model predicts that output and inflation collapse to implausibly low levels and that government spending and forward guidance have implausibly large effects. To resolve these anomalies, we introduce wealth into the utility function; the justification is that wealth is a marker of social status, and people value status. Since people partly save to accrue social status, the Euler equation is modified. As a result, when the marginal utility of wealth is sufficiently large, the dynamical system representing the zero-lower-bound equilibrium transforms from a saddle to a source which resolves all the anomalies.
We thank Sushant Acharya, Adrien Auclert, Gadi Barlevi, Marco Bassetto, Jess Benhabib, Florin Bilbiie, Jeffrey Campbell, Edouard Challe, Varanya Chaubey, John Cochrane, Behzad Diba, Gauti Eggertsson, Erik Eyster, François Gourio, Pete Klenow, Olivier Loisel, Neil Mehrotra, Emi Nakamura, Sam Schulhofer-Wohl, David Sraer, Jon Steinsson, Harald Uhlig, and Ivan Werning for helpful discussions and comments. This work was supported by the Institute for Advanced Study and the Berkeley Center for Equitable Growth.
A supplemental appendix is available online at https://doi.org/10.1162/rest_a_00893.