Incomplete Markets And Households? Exposure To Interest Rate And Inflation Risk: Implications For The Monetary Policy Maker

The present paper studies optimal monetary policy when the representative agent assumption is abandoned and financial wealth heterogeneity across households is introduced. Incomplete market makes households incapable of perfectly insuring against interest rate and inflation risk, creating a trade-off between price level and debt-servicing stabilization. The authors derive a welfare-based loss function for the policymaker, which includes an additional target related to the cross-sectional distribution of household debt. The extent of deviation from price stability depends on the initial level of debt dispersion.