DP12601 Monetary Policy and Heterogeneity: An Analytical Framework

Author(s): Florin Ovidiu Bilbiie
Publication Date: January 2018
Date Revised: January 2019
Keyword(s): determinacy, forward guidance puzzle, HANK, heterogenous agents, liquidity traps and multipliers, monetary policy, Optimal monetary policy, Taylor and Wicksellian rules
JEL(s): E21, E31, E40, E44, E50, E52, E58, E60, E62
Programme Areas: Monetary Economics and Fluctuations
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=12601

An analytical (heterogeneous-agent New-Keynesian) HANK model allows a closed-form treatment of a wide range of NK topics: determinacy properties of interest-rate rules, resolving the forward guidance FG puzzle, amplification and fiscal multipliers, liquidity traps, and optimal monetary policy. The key channel shaping all the model's properties is that of cyclical inequality: whether the income of constrained agents moves less or more than proportionally with aggregate income. With countercyclical inequality, good news on aggregate demand gets compounded, making determinacy less likely and aggravating the FG puzzle (the resolution of which requires procyclical inequality)---a Catch-22, because countercyclical inequality is what HANK (and TANK) models need to deliver desirable amplification. The dilemma can be resolved if a distinct, "cyclical-risk" channel is procyclical enough. Even when both channels are countercyclical a Wicksellian rule of price-level targeting ensures determinacy and cures the puzzle. Optimal monetary policy is isomorphic to RANK and TANK but calls for less inflation stabilization. In a liquidity trap, even with countercyclical inequality and FG amplification, optimal policy does not imply larger FG duration because as FG power increases, so does its welfare cost.