Financial constraints, risk sharing, and optimal monetary policy

57 Pages Posted: 18 Nov 2021

See all articles by Aliaksandr Zaretski

Aliaksandr Zaretski

University of Surrey - School of Economics

Date Written: May 16, 2021

Abstract

I characterize optimal government policy in a sticky-price economy with different types of consumers and endogenous financial constraints in the banking and entrepreneurial sectors. The competitive equilibrium allocation is constrained inefficient due to a pecuniary externality implicit in the collateral constraint and other externalities arising from consumer type heterogeneity. These externalities can be corrected with appropriate fiscal instruments. Independently of the availability of such instruments, optimal monetary policy aims to achieve price stability in the long run and approximate price stability in the short run, as in the conventional New Keynesian environment. Compared to the competitive equilibrium, the constrained efficient allocation significantly improves between-agent risk sharing, approaching the unconstrained Pareto optimum and leading to sizable welfare gains. Such an allocation has lower leverage in the banking and entrepreneurial sectors and is less prone to the boom-bust financial crises and zero-lower-bound episodes observed occasionally in the decentralized economy.

Keywords: constrained efficiency, effective lower bound, financial constraints, leverage limits, optimal monetary policy, Ramsey equilibrium

JEL Classification: E32, E44, E52, E63, G28

Suggested Citation

Zaretski, Aliaksandr, Financial constraints, risk sharing, and optimal monetary policy (May 16, 2021). Available at SSRN: https://ssrn.com/abstract=3962623 or http://dx.doi.org/10.2139/ssrn.3962623

Aliaksandr Zaretski (Contact Author)

University of Surrey - School of Economics

Guildford, Surrey GU2 7XH
United Kingdom

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