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

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  • Andrea Pescatori

Abstract

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.

Suggested Citation

  • Andrea Pescatori, 2007. "Incomplete markets and households’ exposure to interest rate and inflation risk: implications for the monetary policy maker," Working Papers (Old Series) 0709, Federal Reserve Bank of Cleveland.
    • Handle: RePEc:fip:fedcwp:0709
    DOI: 10.26509/frbc-wp-200709
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    References listed on IDEAS

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    Cited by:

    1. Jae Won Lee, 2010. "Heterogeneous Households in a Sticky Price Model," Departmental Working Papers 201001, Rutgers University, Department of Economics.
    2. Jae Won Lee & Seunghyeon Lee, 2025. "Monetary Non-Neutrality in a Multisector Economy: The Role of Risk-Sharing," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 55, January.
    3. Dila Asfuroglu, 2024. "Surprise by Anticipated Inflation," SAGE Open, , vol. 14(2), pages 21582440241, May.
    4. Jae Won Lee, 2014. "Monetary Policy with Heterogeneous Households and Imperfect Risk-Sharing," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 17(3), pages 505-522, July.

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