Welfare measurements with heterogeneous agents

Abstract

The canonical infinite-horizon framework with heterogeneous consumers, commonly used in macroeconomic and financial literature, lacks a preference-based index that consistently quantifies the welfare impacts of economic policies. In particular, the classic money-metric indices, such as equivalent and compensating variations, are not additive across sets of policies, and predictions may depend on the assumed status quo or the order in which alternatives are implemented. This paper offers a positive result. We show that, for arbitrary heterogeneous von Neumann-Morgenstern preferences with a common discount factor, the equivalent (or compensating) variation is nearly additive and aggregates effectively as long as consumers are patient. Consequently, the index provides consistent quantitative welfare predictions for a wide variety of short-lived policies studied in the macroeconomic and finance literature.