Expectations and incomplete markets

In this chapter we examine the role of expectations in a Heterogeneous Agents New Keynesian model with labor market matching frictions (HANK&SAM). We focus on the macroeconomic effects of news and noise shocks, and the potential for purely expectations-driven aggregate fluctuations. The HANK&SAM model delivers new insights on the impact of expectational shocks through three mechanisms: First, because of incomplete markets, households' intertemporal tradeoffs induce a certain type of myopia and a time-varying precautionary savings motive; Second, income risk is endogenous due to labor market frictions; Third, there is a demand-supply interaction due to sticky prices. We characterize circumstances under which these features leave the economy more or less sensitive to expectational shocks.