Household Income Inequality and Optimal Trend Inflation

This paper studies the optimal inflation target in a tractable heterogeneous agent New Keynesian (THANK) model with an occasionally binding zero lower bound, incorporating income inequality, income risk, and countercyclical fiscal policy. We analytically characterize how cyclical and long-run inequality, income risk, and fiscal policy shape the welfare trade-off of trend inflation across households. Greater cyclical inequality and income risk increase the marginal benefits of inflation, especially for hand-to-mouth (HtM) households, while long-run inequality reduces marginal benefits. Quantitatively, income inequality and income risk modestly raise the utilitarian optimal inflation rate relative to the representative agent benchmark. We further show that countercyclical fiscal policies lower the marginal benefit of inflation for all households and reduce the optimal inflation target. Finally, adding wealth inequality in the form of private or government debt, in addition to income inequality, raises the optimal inflation target. (Copyright: Elsevier)