Inequality, portfolio choice and reduced history models

This paper solves a reduced history model with heterogeneous agents, aggregate risk and portfolio choice between a risky, productive and a risk-free, non-productive asset. Motivated by existing empirical evidence and consistent with the portfolio choice theory of precautionary savings I find that the idiosyncrasy in human capital gives rise to heterogeneous asset allocations. The agents with the lower consumption growth save more in the risky asset, whilst poorer agents only use the safe asset, implying that the relative supply of safe assets is a central determinant for the evolution of aggregate consumption. Separately, this paper also improves upon the existing methodology of reduced history representations by finding a global solution, enabling studies of richer environments within this framework. In particular, a study of optimal fiscal policy in a heterogeneous agents model with portfolio choice becomes feasible.