Monetary Policy with Heterogeneous Agents and Credit Constraints

This paper exhibits and quantifies a new theoretical channel of the non-neutrality of inflation transiting through capital market imperfections. Unconstrained households change their financial position in front of a change in the inflation rate, whereas constrained households can not. Thus credit constraints induce heterogeneity in the response of money demand following a change in the inflation rate. Because of this heterogeneity, the standard result on the neutrality of inflation does not hold. To investigate this channel, we model capital market imperfections in a production economy following the approach of Aiyagari (1994). Heterogeneous agents can accumulate financial assets to partially insure against idiosyncratic income risks, but they face a borrowing constraint. We embed in this framework money in the utility function. Thus agents can self-insure with both money and financial titles, and the substitution between these two instruments depends on their relative returns. Firstly we provide theoretical evidence that inflation affects aggregate real variables in this framework with credit constraints. Secondly, we quantify the long-run effect of inflation on aggregate variables by calibrating the model on the United States. We find that credit constraints give rise to quantitatively important departure from the traditional superneutrality result. In the benchmark general equilibrium economy an increase in inflation from 2 percent to 3 percent leads to a rise of 0.39 percent in aggregate capital. Moreover, the average welfare costs of inflation are much lower in incomplete market economy compared to the traditional complete market set-up à la Lucas (2000). A rise by one point in inflation would induce a 30 percent higher decrease in welfare in the complete market economy compared to our framework with credit constraints. Thirdly, inflation has a key redistributive impact. Wealth-poor households benefit from inflation, contrary to the wealthiest households. This result is mainly driven by a price effect: Most the income of the wealth-poor comes from labor whose return rises as aggregate capital increases.