Optimal policy mix for heterogeneous households
A new Bank of Canada staff working paper examines the optimal coordination of conventional and unconventional monetary policy in economies with heterogeneous households and mortgage debt. It finds that optimal policy involves raising short-term rates while simultaneously lowering long-term rates after a cost-push shock.
Heterogeneity alters policy response
This paper examines the optimal coordination of conventional and unconventional monetary policy tools in an economy with heterogeneous households and mortgage debt.
It builds a dynamic stochastic general equilibrium (DSGE) model featuring three household types—savers, borrowers, and renters—and includes housing investment, long-term fixed-rate mortgages, and a housing production sector.
The central bank controls both the short-term interest rate and the long-term rate by adjusting the maturity composition of government bonds.
The authors show that household heterogeneity significantly alters the optimal policy response to macroeconomic shocks.
Specifically, after a cost-push shock, optimal policy calls for increasing the short-term rate to contain inflation while simultaneously lowering the long-term rate to ease financial pressures on indebted households and renters.
This combination speeds up the recovery of investment and output, stabilizes inflation, but exacerbates consumption inequality.
By contrast, in a representative-agent model, the optimal response is to raise both rates.
Distributional consequences matter
The results underscore the need to consider distributional consequences in monetary policy design and indicate that yield curve control can serve as a valuable tool in heterogeneous economies.
The paper contributes to the optimal monetary policy literature by extending the standard New Keynesian framework with long-term fixed-rate mortgage contracts and a housing production sector.
It also introduces a welfare-based criterion that captures the distributional effects of monetary policy on heterogeneous households, offering new insights into the role of unconventional monetary policy in highly indebted household environments.
The post-pandemic inflation surge reignited debates over the appropriate mix of conventional and unconventional tools, amplifying financial burden on indebted households.
Beyond the aggregate
This study provides a crucial framework for understanding how monetary policy impacts different household groups.
Its findings challenge traditional approaches by advocating for a nuanced policy mix that considers both inflation and financial stability.
Policymakers must now grapple with the trade-offs between aggregate stability and consumption inequality.