Abstract
We study optimal policy design in a monetary model with heterogeneous preferences. In the model markets are incomplete and households are heterogeneous with respect to their current consumption preferences and discount factors. The government controls the supply of money (liquid) and nominal bonds (illiquid) based on which households make optimal portfolio choices. We uncover that the two types of preference heterogeneity have distinct implications for the optimal policy mix of the government. While the heterogeneity in current consumption preferences pushes the economy towards a zero-lower-bound (ZLB) associated with nominal interest rates, the heterogeneity in discount factors moves the economy away from the ZLB. We characterize the optimal policy design and quantify the welfare losses associated a binding ZLB - and thus potential welfare benefits from allowing negative interest rates on government bonds.
Highlights
An extensive quantitative-macro literature studies cross-sectional variance of consumption over the life-cycle.1 Some papers in this line of research highlight the relevance of heterogeneous preferences in accounting for variance in consumption.2 Preference heterogeneity may exacerbate inequality and cause welfare losses when financial markets are incomplete3 or when fiscal policy is set sub-optimally.4In this paper, we approach the interaction between preference heterogeneity and consumption variability over the lifecycle from a different perspective: To what extent can monetary policy correct the distributional consequences of heterogeneous preferences and improve welfare when markets are incomplete? There are two main contributions of our paper to the literature
We show that when a condition governed by this statistic is met, an endogenous zero lower bound (ZLB) on nominal interest rates gets reached
In an OLG framework with shocks to both the marginal utility from current consumption and subjective discount factors, the current paper demonstrates that bonds are essential when discount factor shocks dominate in characterizing preference heterogeneity
Summary
An extensive quantitative-macro literature studies cross-sectional variance of consumption over the life-cycle. Some papers in this line of research highlight the relevance of heterogeneous preferences (mainly in the form of discount factor shocks) in accounting for variance in consumption. Preference heterogeneity may exacerbate inequality and cause welfare losses when financial markets are incomplete or when fiscal policy is set sub-optimally.. On the one hand, when households are relatively heterogeneous in terms of their preference to consume early (current MU) and not that heterogeneous with respect to late consumption preferences (discount factors) - the test statistic is low and the economy reaches the ZLB. In this respect, our analysis reveals that increasing heterogeneity of impatience (current MU) and patience (discount factors) have different consequences for government’s ability to freely choose an optimal nominal interest rate in its policy mix. On the other hand, when the relative standard deviation of first-best late consumption equals one (as another benchmark), the optimal policy increases steady state welfare by 1.2% of the first-best level of welfare This quantitatively substantial difference is caused by the fact that the ZLB binds in the former case but not in the latter. Figures can be found in Appendix A, and proofs and derivations can be found in Appendix B
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