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Monetary Policy with Heterogeneous Households and Financial Frictions

  • Jae Won Lee


    (Rutgers University, Department of Economics)

This paper presents and estimates a sticky-price model with heterogenous households and financial frictions. Frictions in state-contingent asset markets lead to imperfect risk-sharing among households with idiosyncratic labor incomes. I study the impacts of the introduced financial frictions on optimal monetary policy by documenting implications for the central bank's objective function, the equation that characterizes inflation-output gap trade-offs, targeting rules, interest rate rules, and welfare of the economy. Employing the estimated model, the paper argues that the central bank should place a stronger emphasis on stabilizing inflation than it has, and failing to do so can generate nontrivial welfare costs.

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Paper provided by Rutgers University, Department of Economics in its series Departmental Working Papers with number 201002.

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Length: 20 pages
Date of creation: 12 Feb 2010
Date of revision:
Handle: RePEc:rut:rutres:201002
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  1. Richard Clarida & Jordi Gali & Mark Gertler, 2002. "A Simple Framework for International Monetary Policy Analysis," NBER Working Papers 8870, National Bureau of Economic Research, Inc.
  2. Marvin Goodfriend & Robert King, 1997. "The New Neoclassical Synthesis and the Role of Monetary Policy," NBER Chapters, in: NBER Macroeconomics Annual 1997, Volume 12, pages 231-296 National Bureau of Economic Research, Inc.
  3. Richard Clarida & Jordi Galí & Mark Gertler, 1997. "The science of monetary policy: A new Keynesian perspective," Economics Working Papers 356, Department of Economics and Business, Universitat Pompeu Fabra, revised Apr 1999.
  4. Benigno, Pierpaolo, 2004. "Optimal monetary policy in a currency area," Journal of International Economics, Elsevier, vol. 63(2), pages 293-320, July.
  5. repec:tpr:qjecon:v:125:y:2010:i:3:p:961-1013 is not listed on IDEAS
  6. Smets, Frank & Wouters, Rafael, 2007. "Shocks and Frictions in US Business Cycles: A Bayesian DSGE Approach," CEPR Discussion Papers 6112, C.E.P.R. Discussion Papers.
  7. Mark Bils & Peter J. Klenow, 2002. "Some Evidence on the Importance of Sticky Prices," NBER Working Papers 9069, National Bureau of Economic Research, Inc.
  8. Krusell, P & Smith Jr, A-A, 1995. "Income and Wealth Heterogeneity in the Macroeconomic," RCER Working Papers 399, University of Rochester - Center for Economic Research (RCER).
  9. Svensson, Lars E.O., 1997. "Inflation Targeting: Some Extensions," Seminar Papers 625, Stockholm University, Institute for International Economic Studies.
  10. Frank Smets & Raf Wouters, 2002. "An estimated dynamic stochastic general equilibrium model of the euro area," Working Paper Research 35, National Bank of Belgium.
  11. Jonathan Heathcote & Kjetil Storesletten & Giovanni L. Violante, 2009. "Quantitative macroeconomics with heterogeneous households," Staff Report 420, Federal Reserve Bank of Minneapolis.
  12. Lawrence J. Christiano & Martin Eichenbaum & Charles L. Evans, 2001. "Nominal rigidities and the dynamic effects of a shock to monetary policy," Proceedings, Federal Reserve Bank of San Francisco, issue Jun.
  13. Pierpaolo Benigno & Michael Woodford, 2006. "Linear-Quadratic Approximation of Optimal Policy Problems," NBER Working Papers 12672, National Bureau of Economic Research, Inc.
  14. Vasco Cúrdia & Michael Woodford, 2010. "Conventional and unconventional monetary policy," Review, Federal Reserve Bank of St. Louis, issue May, pages 229-264.
  15. Gertler, Mark & Karadi, Peter, 2011. "A model of unconventional monetary policy," Journal of Monetary Economics, Elsevier, vol. 58(1), pages 17-34, January.
  16. Andrew Levin & Christopher J. Erceg & Dale W. Henderson, 1999. "Optimal Monetary Policy with Staggered Wage and Price Contracts," Computing in Economics and Finance 1999 1151, Society for Computational Economics.
  17. Sam Schulhofer-Wohl, 2007. "Heterogeneity, Risk Sharing and the Welfare Costs of Risk," 2007 Meeting Papers 926, Society for Economic Dynamics.
  18. Emi Nakamura & Jón Steinsson, 2008. "Monetary Non-Neutrality in a Multi-Sector Menu Cost Model," NBER Working Papers 14001, National Bureau of Economic Research, Inc.
  19. repec:tpr:qjecon:v:109:y:1994:i:3:p:659-84 is not listed on IDEAS
  20. Aoki, Kosuke, 2001. "Optimal monetary policy responses to relative-price changes," Journal of Monetary Economics, Elsevier, vol. 48(1), pages 55-80, August.
  21. Vasco Cúrdia & Michael Woodford, 2008. "Credit frictions and optimal monetary policy," Working Paper Research 146, National Bank of Belgium.
  22. Matteo Iacoviello, 2002. "House prices, borrowing constraints and monetary policy in the business cycle," Boston College Working Papers in Economics 542, Boston College Department of Economics, revised 06 Dec 2004.
  23. Berry, Steven & Levinsohn, James & Pakes, Ariel, 1995. "Automobile Prices in Market Equilibrium," Econometrica, Econometric Society, vol. 63(4), pages 841-90, July.
  24. 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.
  25. Julio Rotemberg & Michael Woodford, 1997. "An Optimization-Based Econometric Framework for the Evaluation of Monetary Policy," NBER Chapters, in: NBER Macroeconomics Annual 1997, Volume 12, pages 297-361 National Bureau of Economic Research, Inc.
  26. Dixit, Avinash K & Stiglitz, Joseph E, 1977. "Monopolistic Competition and Optimum Product Diversity," American Economic Review, American Economic Association, vol. 67(3), pages 297-308, June.
  27. S. Rao Aiyagari, 1993. "Uninsured idiosyncratic risk and aggregate saving," Working Papers 502, Federal Reserve Bank of Minneapolis.
  28. Yun, Tack, 1996. "Nominal price rigidity, money supply endogeneity, and business cycles," Journal of Monetary Economics, Elsevier, vol. 37(2-3), pages 345-370, April.
  29. repec:clu:wpaper:0809-02 is not listed on IDEAS
  30. Calvo, Guillermo A., 1983. "Staggered prices in a utility-maximizing framework," Journal of Monetary Economics, Elsevier, vol. 12(3), pages 383-398, September.
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