This paper introduces the random discounted expected utility (RDEU) model, which we have developed as a means to deal with heterogeneous risk and time preferences. The RDEU model provides an explicit linkage between preference and choice heterogeneity. We prove it has solid comparative statics, discuss its identification, and demonstrate its computational convenience. Finally, we use two distinct experimental datasets to illustrate the advantages of the RDEU model over common alternatives for estimating heterogeneity in preferences across individuals.

Consumers rely on their shopping experiences to form beliefs about inflation. In other words, they learn by shopping. I introduce this empirical observation as an informational friction in the New Keynesian model and study its consequences for the transmission of aggregate shocks. Learning by shopping anchors households’ beliefs about inflation to past inflation, making them disagree with firms about the value of the real wage. This disagreement allows nominal shocks to have real effects. It also makes the slope of the Phillips curve a function of the degree of anchoring, which is endogenous and depends on the monetary policy stance. A more hawkish monetary policy, like the one observed in the post-Volcker era, anchors households’ inflation expectations, flattens the Phillips curve, and reduces the volatility and persistence of inflation. Such a policy also alters the drivers of business cycles, diminishing the impact of supply shocks on output while making it more susceptible to exogenous shifts in aggregate demand.

Deleveraging shocks that increase household precautionary savings, and financial and uncertainty shocks to firms, interact and amplify each other, even when these same shocks separately have moderate effects on output and employment. This result is obtained in a model in which heterogeneous households face financial frictions and unemployment risk and in which heterogeneous firms borrow funds using nominally fixed long-term debt and face costly bankruptcy. This novel amplification mechanism is based on a dynamic feedback between the precautionary behavior of households and the bankruptcy and entry decisions of firms. Our results support the view that firm financial frictions are important to understand the effect of household deleveraging on unemployment, consistent with recent empirical studies examining the 2007-2009 Great Recession.