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Incomplete Markets and Households’ Exposure to Interest Rate and Inflation Risk: Implications for the Monetary Policy Maker


The present paper studies optimal monetary policy when the representative agent assumption is abandoned and financial wealth heterogeneity across households is introduced. Incomplete market makes households incapable of perfectly insuring against interest rate and inflation risk, creating a trade-off between price level and debt-servicing stabilization. We derive a welfare-based loss function for the policymaker, which includes an additional target related to the cross-sectional distribution of household debt. The extent of deviation from price stability depends on the initial level of debt dispersion. Using U.S. microdata to calibrate the model, we find an optimal inflation volatility equal to almost 20% of the actual volatility of the last 15 years. Finally, the paper studies the design of optimal simple implementable rules. Superinertial rules, which imply a hump-shaped interest rate response to shocks, significantly outperform standard rules.

JEL codes: E52, E31, C60, D31, D52

Keywords: optimal monetary policy, household debt, debt servicing, inflation volatility, redistribution, business cycle


Suggested citation: Pescatori, Andrea, 2007. "Interest Rate and Inflation Risk: Implications for the Monetary Policy Maker," Federal Reserve Bank of Cleveland, Working Paper no. 07-09.

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