Monetary policy with heterogeneous households and imperfect risk-sharing

This paper considers a sticky-price model with heterogeneous households and financial frictions. Financial frictions lead to imperfect risk-sharing among households with idiosyncratic labor incomes. I study implications of imperfect risk-sharing for optimal monetary policy by documenting its impacts on the monetary transmission mechanism, the inflation–output tradeoff faced by the central bank, the policy objective function, and the resulting targeting rule. The main finding is that while the central bank continues to have the conventional dual mandate — the output gap and inflation stabilization — it should place a greater weight on the later as the degree of financial frictions increases because price stability provides the additional benefit of reducing undesired consumption dispersion.