Discussion Paper Details

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Title: Optimal Monetary Policy and Liquidity with Heterogeneous Households

Author(s): Florin Ovidiu Bilbiie and Xavier Ragot

Publication Date: January 2017

Keyword(s): heterogenous agents, incomplete markets, limited participation, liquidity constraints, money and optimal (Ramsey) monetary policy

Programme Area(s): Monetary Economics and Fluctuations

Abstract: A novel liquidity-insurance motive for monetary policy implies optimal deviations from price stability when heterogeneous households who participate infrequently in financial markets use liquidity to insure idiosyncratic risk. In our tractable sticky-price model that can be solved in closed form, aggregate demand depends on liquidity. The liquidity-insurance motive changes the central bank?s trade-off, which is nevertheless still described by a quadratic approximation to aggregate welfare. Price stability has significant welfare costs because inflation volatility hinders the consumption volatility of constrained households as a side-effect of liquidity-insuring them. Helicopter drops are a better way to achieve this insurance than open-market operations.

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Bibliographic Reference

Bilbiie, F and Ragot, X. 2017. 'Optimal Monetary Policy and Liquidity with Heterogeneous Households'. London, Centre for Economic Policy Research.