Incomplete Markets and Households ’ Exposure to Interest Rate and Infl ation Risk : Implications for the Monetary Policy

Working papers of the Federal Reserve Bank of Cleveland are preliminary materials circulated to stimulate discussion and critical comment on research in progress. They may not have been subject to the formal editorial review accorded offi cial Federal Reserve Bank of Cleveland publications. The views stated herein are those of the authors and are not necessarily those of the Federal Reserve Bank of Cleveland or of the Board of Governors of the Federal Reserve System. The present paper studies optimal monetary policy when the representative agent assumption is abandoned and fi nancial wealth heterogeneity across households is introduced. Incomplete market makes households incapable of perfectly insuring against interest rate and infl ation 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 deviation from price stability depends on the initial level of debt dispersion. Using U.S. microdata to calibrate the model, we fi nd an optimal infl ation volatility equal to almost 20% 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, signifi cantly outperform standard rules.