Heterogeneity, monetary policy and business cycles

This paper is an attempt to shed more light on the effects of monetary policy on different population groups. We call for a reconsideration of the famous proposition by Rogoff (1985) that in order to avoid the outcome dubbed “inflation bias,” whereby the central bank is tempted to generate inflation in order to boost output, a more conservative central banker ought to be appointed. We argue that if attaining Pareto efficiency is desirable, a more conservative central banker should be appointed. But our result does not depend on the key assumption used by Rogoff that the economy has some sort of distortion (in the labor market) that introduces a trade-off for the central bank. The trade-off in this paper arises from heterogeneity in productivity among workers.

The other theme in the paper is the design of central banks. Most central banks are governed by monetary policy committees, but some are governed by single governors. Those governed by committees may be headed by “strong” chairmen such as Alan Greenspan, or by consensus seekers such as Ben Bernanke in the United States. One may think of central banks headed by single governors or strong chairs as “personality-driven,” and the rest as “consensus-driven.”  Our paper argues that consensus-driven central banks deliver better outcomes.

We use a version of the New-Keynesian model with heterogeneous agents. Some agents are more productive and some less. The central bank preferences are a weighted average of household preferences. We show that when the central bank preferences are unbiased, i.e. the weights on the two utilities are equal to the corresponding fractions of the population, the Friedman Rule does not hold and thus the equilibrium allocation is not Pareto efficient. We demonstrate that Pareto efficiency can be attained only when the central bank puts more weight on the utility of more productive workers.

The paper provides some recommendations on complements to monetary policy such as fiscal policy and macroprudential regulation of financial institutions.