Inequality, Business Cycles, and Monetary-Fiscal Policy

We study optimal monetary and fiscal policies in a New Keynesian model with heterogeneous agents, incomplete markets, and nominal rigidities. Our approach uses small-noise expansions and Frechet derivatives to approximate equilibria quickly and efficiently. Responses of optimal policies to aggregate shocks differ qualitatively from what they would be in a corresponding representative agent economy and are an order of magnitude larger. A motive to provide insurance that arises from heterogeneity and incomplete markets outweighs price stabilization motives.

Automated summary

In this study, optimal monetary and fiscal policies in a New Keynesian model with heterogeneous agents, incomplete markets, and nominal rigidities were analyzed. The approach utilized small-noise expansions and Frechet derivatives to quickly and efficiently approximate equilibria. The study found that responses of optimal policies to aggregate shocks were qualitatively different and significantly larger than in a representative agent economy, with insurance motives outweighing price stabilization motives due to heterogeneity and incomplete markets.