Optimal Monetary Policy and Liquidity with Heterogeneous Households

59 Pages Posted: 30 Jan 2017 Last revised: 31 Jul 2017

Date Written: January 2017

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.

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

JEL Classification: D14, D31, E21, E3, E4, E5

Suggested Citation

Bilbiie, Florin Ovidiu and Ragot, Xavier, Optimal Monetary Policy and Liquidity with Heterogeneous Households (January 2017). CEPR Discussion Paper No. DP11814, Available at SSRN: https://ssrn.com/abstract=2908227

Florin Ovidiu Bilbiie (Contact Author)

University of Oxford ( email )

Oxford
United Kingdom

Xavier Ragot

Banque de France ( email )

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