Incomplete Markets, Idiosyncratic Shocks and Optimal Monetary Policy

A widespread result in monetary policy literature is that the price level should be stabilized and, as corollary, the nominal interest rate should vary with the Wicksellian determinants of the real interest rate. The present paper studies how this result is altered when the representative agent assumption is abandoned and financial wealth heterogeneity across households is introduced. I derive a welfare-based loss function for the policy maker which includes an additional target related to the cross-sectional distribution of household debt. My results differ from standard ones in two respects. First, thanks to its ability to affect interest payments volatility, monetary policy has real effects even in a flexible-price cashless-limit environment. Second, in a setup with nominal rigidities, price stability is no longer optimal. The extent of deviation from price stability depends on the initial level of debt dispersion. I use US micro data to calibrate the model and I find that the departure from price stability is still relatively small under the baseline calibration. Finally, the paper also studies the design of an optimal simple implementable rule. I find that superinertial rules I thank Albert Marcet, Michael Reiter for precious comments. I also thank Jean Boivin, Mike Golosov, Guido Lorenzoni, Alberto Martin, Christian Haefke, Jinill Kim, Thijs van Rens, Jaume Ventura, Tack Yun, and seminar participants at Pompeu Fabra, Cleveland FED, Board of Governors, IFW-Kiel, Ente L. Einaudi (Bank of Italy), Universidad Carlos III, Bank of Finland, Bank of Spain, HEC Lausanne, HEC Montreal, the EEA Meetings in Vienna, for very helpful comments. I am particularly indebted to Jordi Gali for his valuable advice and suggestions. All errors are mine. Department of Economics, Universitat Pompeu Fabra, Ramon Trias Fargas 25, 08005, Barcelona, Spain. Email:andrea.pescatori@upf.edu