Monetary Policy with Heterogeneous Households and Financial Frictions

This paper presents and estimates a sticky-price model with heterogeneous households and financial frictions. Frictions in state-contingent asset markets lead to imperfect risk-sharing among households with idiosyncratic labor incomes. I study the impacts of the introduced …financial frictions on optimal monetary policy by documenting implications for the central bank's objective function, the equation that characterizes inflation-output gap trade-offs, targeting rules, interest rate rules, and welfare of the economy. Employing the estimated model, the paper argues that the central bank should place a stronger emphasis on stabilizing inflation than it has, and failing to do so can generate nontrivial welfare costs.