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Incomplete markets and households’ exposure to interest rate and inflation risk: implications for the monetary policy maker

  • Andrea Pescatori

The present paper studies optimal monetary policy when the representative agent assumption is abandoned and financial wealth heterogeneity across households is introduced. Incomplete markets make households incapable of perfectly insuring against interest rate and inflation risk, creating a trade-off between price level and debt-servicing stabilization. We derive a welfare-based loss function for the policymaker, which includes an additional target related to the cross-sectional distribution of household debt. The extent of the deviation from price stability depends on the initial level of debt dispersion. Using U.S. microdata to calibrate the model, we find an optimal inflation volatility equal to almost 20 percent of the actual volatility of the last 15 years. Finally, the paper studies the design of optimal simple implementable rules. Superinertial rules, which imply a hump-shaped interest rate response to shocks, significantly outperform standard rules.

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Paper provided by Federal Reserve Bank of Cleveland in its series Working Paper with number 0709.

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Date of creation: 2007
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Handle: RePEc:fip:fedcwp:0709
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  1. Albanesi, Stefania, 2007. "Inflation and inequality," Journal of Monetary Economics, Elsevier, vol. 54(4), pages 1088-1114, May.
  2. Per Krusell & Anthony A. Smith, Jr., . "Income and Wealth Heterogeneity in the Macroeconomy," GSIA Working Papers 1997-37, Carnegie Mellon University, Tepper School of Business.
  3. Aubhik Khan & Robert G. King & Alexander L. Wolman, 2000. "Optimal monetary policy," Working Paper 00-10, Federal Reserve Bank of Richmond.
  4. Sbordone, A.M., 1998. "Prices and Unit Labor Costs: a New Test of Price Stickiness," Papers 653, Stockholm - International Economic Studies.
  5. Stephanie Schmitt-Grohe & Martin Uribe, 2001. "Closing Small Open Economy Models," Departmental Working Papers 200115, Rutgers University, Department of Economics.
  6. Pierpaolo Benigno & Michael Woodford, 2005. "Inflation Stabilization And Welfare: The Case Of A Distorted Steady State," Journal of the European Economic Association, MIT Press, vol. 3(6), pages 1185-1236, December.
  7. Bennett T. McCallum, 2001. "Monetary policy analysis in models without money," Review, Federal Reserve Bank of St. Louis, issue Jul, pages 145-164.
  8. Marc P. Giannoni & Michael Woodford, 2003. "Optimal Interest-Rate Rules: II. Applications," Levine's Bibliography 506439000000000394, UCLA Department of Economics.
  9. Svensson, L.E.O., 1998. "Inflation Targeting as a Monetary Policy Rule," Papers 646, Stockholm - International Economic Studies.
  10. Miao, Jianjun, 2006. "Competitive equilibria of economies with a continuum of consumers and aggregate shocks," Journal of Economic Theory, Elsevier, vol. 128(1), pages 274-298, May.
  11. Lucas, Robert Jr. & Stokey, Nancy L., 1983. "Optimal fiscal and monetary policy in an economy without capital," Journal of Monetary Economics, Elsevier, vol. 12(1), pages 55-93.
  12. Marc P. Giannoni & Michael Woodford, 2003. "Optimal Interest-Rate Rules: I. General Theory," Levine's Bibliography 506439000000000384, UCLA Department of Economics.
  13. Huggett, Mark, 1993. "The risk-free rate in heterogeneous-agent incomplete-insurance economies," Journal of Economic Dynamics and Control, Elsevier, vol. 17(5-6), pages 953-969.
  14. Eric R Young, 2005. "Approximate Aggregation," Computing in Economics and Finance 2005 141, Society for Computational Economics.
  15. Henry Kim & Jinill Kim & Robert Kollmann, 2005. "Applying Perturbation Methods to Incomplete Market Models with Exogenous Borrowing Constraints," Discussion Papers Series, Department of Economics, Tufts University 0504, Department of Economics, Tufts University.
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