Macroeconomics is evolving from the study of aggregate dynamics to the study of the dynam-ics of the entire equilibrium distribution of allocations across individual economic actors. This article reviews the quantitative macroeconomic literature that focuses on household hetero-geneity, with a special emphasis on the “standard ” incomplete markets model. We organize the vast literature according to three themes that are central to understanding how inequality matters for macroeconomics. First, what are the most important sources of individual risk and cross-sectional heterogeneity? Second, what are individuals ’ key channels of insurance? Third, how does idiosyncratic risk interact with aggregate risk? *This paper was prepared for Volume 1 of the Annual Review of Economics. Heathcote and Violante thank the National Science Foundation (Grant SES-0418029). The views expressed herein are those of the authors and not necessarily those of the Federal Reserve Bank of Minneapolis or the Federal Reserve System. 1

In this paper we first document inequality trends in wages, hours worked, earnings, consumption, and wealth for Germany from the last twenty years. We generally find that inequality was relatively stable in West Germany until the German unification (which happened politically in 1990 and in our data in 1991), and then trended upwards for wages and market incomes, especially after about 1998. Disposable income and consumption, on the other hand, display only a modest increase in inequality over the same period. These trends occured against the backdrop of lower trend growth of earnings, incomes and consumption in the 1990s relative to the 1980s. In the second part of the paper we further analyze the differences between East and West Germans in terms of the evolution of levels and inequality of wages, income, and consumption.

No question has perhaps attracted as much attention in the economics literature as “Why are some countries richer than others? ” In this paper, we revisit the development problem and reevaluate the role of human capital. The key difference between our paper and recent work in this area is that we use theory to estimate the stocks of human capital, and that we allow the quality of human capital to vary across countries. When quality differences are allowed, we find that effective human capital per worker varies substantially across countries. As a result of this finding, we estimate that cross-country differences in Total Factor Productivity (TFP) are significantly smaller than those reported in previous studies. Moreover, our model implies that output per worker is highly responsive to differences in TFP and in demographic variables.

I introduce endogenous human-capital accumulation into an infinitehorizon version of Chari & Hopenhayn’s (1991) vintage-human-capital model. Different skill levels inside a vintage are complementary in production. I establish equivalence between competitive equilibrium and a planner’s problem, which ensures uniqueness of equilibrium. Returns to skill and tenure premia are highest in young vintages, where skill is scarcest and agents accumulate human capital fastest. As the vintage ages, the skill premium decreases and vanishes entirely upon vintage death. The results are in line with German linked employer-employee data: Young establishments pay higher tenure premia but lower mean wages than old establishments.

The standard life-cycle incomplete-markets model, where households face idiosyncratic earnings shocks and trade a non-contingent asset, is a workhorse of quantitative macroeconomics. In this paper, we assess the degree of consumption insurance implicit in a plausibly calibrated version of the model, and we compare it to the data. On both actual and simulated data, we apply a technique recently developed by Blundell, Pistaferri and Preston (2006, BPP thereafter). We find that households in Bewley models have access to less consumption smoothing against permanent shocks than what is measured in the data. BPP estimate that 36 % of permanent earnings shocks are insurable (i.e., do not translate into consumption growth), while in the model this insurance coefficient is only 17%. The life-cycle profile of insurance coefficients is sharply increasing and convex in the model, while BPP document that it is roughly flat in the data. Taken at face value, these results would suggest that macroeconomists should develop models with more avenues of insurance than a risk-free asset. Allowing for “advance information ” about earnings changes in the model does not affect this conclusion. However, we also find that if earnings shocks are not modelled to be permanent, as assumed by BPP, but they display an autocorrelation coefficient

Separate identification of the price and quantity of human capital has important implications for understanding key issues in labor economics and macroeconomics. Price and quantity series are derived and subjected to robustness checks. The human capital price series associated with different education levels are highly correlated and exhibit a strong secular trend. Three resulting implications are explored: (1) using the derived quantities life-cycle profiles are re-examined; (2) the rising college premium is reinterpreted and found to be mainly driven by relative quantity changes, and (3) adjusting the labor input for quality increases dramatically reduces the contribution of MFP to growth. The authors wish to thank Lance Lochner and Todd Stinebrickner for helpful comments and discussion. We

Abstract I analyze the effect of an unexpected influx of immigrants on the price of skill and hence on the earnings, human capital accumulation, and educational attainment of native workers. In order to study these effects, I develop a general equilibrium model with heterogeneous workers who differ in their level of skill and in their ability to learn new skills. These workers accumulate human capital optimally using information about the current and future market price of skill to guide their decisions. To assess the impact of immigration, I compare simulated earnings in the presence of immigration with a series of counterfactual experiments. My findings suggest that immigration has a small negative direct effect on earnings, but a positive and relatively large impact indirectly through human capital accumulation and educational attainment. This latter mechanism explains 60% of the variations in earnings caused by immigration.

Abstract Using panel data from the National Longitudinal Survey of Youth (NLSY), we document that gender differences in wages almost double during the first 20 years of labor market experience and that there are substantial gender differences in employment and hours of work during the life cycle. A large portion of gender differences in labor market attachment can be traced to the impact of children on labor supply of women. We develop a quantitative life-cycle model of fertility, labor supply, and human capital accumulation decisions. We use this model to assess the role of fertility on gender differences in labor supply and wages over the life cycle. In our model, fertility (expected and actual) lowers the lifetime intensity of market activity, reducing the incentives for human capital accumulation and wage growth over the life cycle relative to males. We calibrate the model to panel data of men and to fertility and child related labor market histories of women. We find that fertility accounts for most of the gender differences in labor supply and wages during the life cycle documented in the NLSY data.

I study the aggregate implications of health risk and access to health care. At the in-dividual level, health influences earnings potential, while income affects access to medical care. I investigate how this interaction shapes the joint dynamics of inequality in health and earnings over the life cycle, and I measure the redistributive impact of policies that improve access to health care. For that, I introduce health shocks and health care spend-ing in an incomplete markets model with heterogeneous agents. Earnings risk is partially determined within the model due to the health-income feedback, and negative shocks may drive agents into a low income-low health trap, thus magnifying inequality along the life cycle. I estimate the process for health shocks and I calibrate the key parameters of the model using survey data. The calibrated model successfully reproduces the joint dynamics in health and earnings inequality in the life cycle. Like in the data, it predicts that life cycle inequality in health is driven by a sharp decline in health status for the lowest percentiles of the health distribution. I find that the health-income feedback accounts for 17 percent of total earnings inequality, and that it increases by seven times the persistence of shocks to productivity. I also find that health care policies that facilitate access to health care have redistributive effects, mostly through earnings improvements for those at the bottom of the earnings distribution.

The quantitative features of human capital externalities are not fully understood. While static externalities are estimated in some studies, learning externalities remain mostly unestimated. By calibrating a growth model, this paper provides an estimate of learning externalities. The calibration uses an equilibrium condition that equates private returns on physical capital and human capital. The results suggest that sizable learning externalities exist, even in a conservative set-up. The estimated social rate of return on human capital is 9.0 percent, compared to the private rate of return, 6.6 percent. Therefore, human capital externalities are an important source of economic growth.