Rationality, inequality, and the output gap: evidence from a disaggregated Keynesian cross diagram

This paper examines the conditions under which a representative agent (RA) model can accurately approximate the output of a multi-agent model that assumes many interacting agents. The study compares the widely used Keynesian cross diagram, which employs a representative agent, to an extended model that explicitly considers multiple interacting households and firms. The extended model reduces to the original RA model when there is one agent of each type. The findings suggest that the RA Keynesian cross diagram model does not accurately approximate the extended multi-agent model when: (1) the network structure of the economy is asymmetric (e.g., firms have different sizes), or (2) the rationality of agents is too low. Additionally, when income inequality is considered by introducing capitalists, the RA model is no longer a good approximation, even if agents are rational. However, fiscal policies that redistribute income can improve the accuracy of the RA model’s predictions. In general, features that increase the overall rationality of the economy and decrease heterogeneity tend to improve the performance of the RA approximation.