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.