Heterogeneity and monetary policy

While the representative-agent framework has been the workhorse in macroeconomics over the last several decades, economists have long been interested in heterogeneity. It has been recognized that many important questions cannot be addressed without heterogeneity. One such issue, inequality, after being mostly ignored for a long time, is becoming a booming area of study. Many authors have started investigating the effect of monetary policy on inequality. While this effect is found to be significant, this paper argues that monetary policy is not an adequate tool to address this issue. The paper builds a model with a heterogeneous population in which monetary policy is shown to have different effects on different groups of the population. Calibration is used to pin down values of several parameters in the model, data from the Congressional Budget Office is used for this. In this simple environment with heterogeneous agents, we demonstrate that the Friedman rule allocation cannot be obtained if the goal is maximization of social welfare. We show that a central bank concerned with inequality has a tendency to choose a higher level of inflation than efficiency dictates: up to a certain level, inflation decreases inequality. We build a simple model with heterogeneous agents and obtain a result akin to Rogoff (1985): if Pareto efficiency is important then appointing a more "conservative'' central bank that puts a higher weight on the utility of the high-productivity workers improves the macroeconomic outcome. And this effect is only due to heterogeneity and disappears as homogeneity is restored. The degree of "conservatism'' needed of the central bank increases in heterogeneity and the importance of consumption in preferences. One possible interpretation of our results is to question the recent wisdom of thinking of inequality as part of central bank concerns.

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