DP11814 Optimal Monetary Policy and Liquidity with Heterogeneous Households

Author(s): Florin Ovidiu Bilbiie, Xavier Ragot
Publication Date: January 2017
Date Revised: July 2017
Keyword(s): heterogenous agents, incomplete markets, limited participation, liquidity constraints, money, optimal (Ramsey) monetary policy
JEL(s): D14, D31, E21, E3, E4, E5
Programme Areas: Monetary Economics and Fluctuations
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=11814

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.