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Optimal monetary policy with search frictions and consumption inequality

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  • Lee, Seungcheol

Abstract

This paper investigates optimal monetary policy in a two-agent New Keynesian model with search and matching frictions. We demonstrate that the inability of hand-to-mouth households to smooth consumption via financial markets or the intensive margin of labor supply generates inherent consumption volatility. A numerical second-order welfare evaluation reveals that this volatility, magnified by steady-state inequality acting as a structural amplifier, generates cyclical losses. Consequently, the central bank must prioritize labor income stabilization over strict price stability. Furthermore, we uncover a reversal result: unlike representative-agent benchmarks, under inequality, weaker labor market institutions compel the monetary authority to tolerate greater inflation volatility. Empirical evidence from a cross-country OECD panel supports this mechanism. We confirm that stronger institutions, proxied by union density and replacement ratios, act as macroeconomic stabilizers operating through dual channels, mitigating the structural amplifier and directly buffering cyclical volatility, thereby jointly dampening both nominal and real fluctuations.

Suggested Citation

  • Lee, Seungcheol, 2026. "Optimal monetary policy with search frictions and consumption inequality," Economic Modelling, Elsevier, vol. 160(C).
    • Handle: RePEc:eee:ecmode:v:160:y:2026:i:c:s0264999326001483
    DOI: 10.1016/j.econmod.2026.107619
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    Keywords

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    JEL classification:

    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • E24 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Employment; Unemployment; Wages; Intergenerational Income Distribution; Aggregate Human Capital; Aggregate Labor Productivity
    • E21 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Consumption; Saving; Wealth
    • J51 - Labor and Demographic Economics - - Labor-Management Relations, Trade Unions, and Collective Bargaining - - - Trade Unions: Objectives, Structure, and Effects
    • J65 - Labor and Demographic Economics - - Mobility, Unemployment, Vacancies, and Immigrant Workers - - - Unemployment Insurance; Severance Pay; Plant Closings

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