Buffer-stock saving in a Krusell-Smith world

- Evidence supports Friedman's idea that income has transitory and permanent parts.
- We solve the model of Krusell and Smith (1998) with such an income process.
- Large permanent shocks help our model explain much of empirical wealth heterogeneity.
- Wealth heterogeneity is largely unexplained in the Krusell and Smith (1998) model.

We modify the widely-used Krusell and Smith (1998) model (KS) to accommodate an income process with permanent and transitory components. Appropriately calibrated permanent shocks help explain a substantial part of the empirical wealth heterogeneity unexplained in the baseline KS model.