DNB paper reveals optimal monetary policy mix for heterogeneous economies
A new working paper by De Nederlandsche Bank (DNB) examines the optimal coordination of conventional and unconventional monetary policy tools in economies with household heterogeneity and mortgage debt. It finds that raising short-term rates while lowering long-term rates is optimal to combat inflation and ease financial burdens.
Balancing inflation and household debt
The paper develops a dynamic stochastic general equilibrium (DSGE) model featuring three household types: patient savers, impatient borrowers, and hand-to-mouth renters, alongside housing investment and fixed-rate long-term mortgages.
The central bank in the model controls both the short-term interest rate and the long-term rate through adjustments in the relative supply of long-term government bonds.
A key finding is that household heterogeneity significantly alters the optimal policy response to macroeconomic shocks.
Specifically, following an adverse cost-push shock, the optimal strategy involves raising the short-term rate to counter inflation while simultaneously reducing the long-term rate.
This dual approach aims to mitigate negative wealth effects on indebted households and rental burdens on renters, supporting a faster recovery in housing and total investment.
Beyond the representative agent
This policy mix, which accelerates investment recovery, also leads to a widening of consumption inequality.
In contrast, a representative-agent economy, lacking household heterogeneity and mortgage debt, would optimally raise both short- and long-term rates in response to inflationary shocks.
The research extends the standard New Keynesian framework by incorporating long-term fixed-rate mortgage contracts and a housing production sector, offering a richer analysis of monetary policy transmission through the housing market.
It introduces a welfare-based criterion that accounts for the distributional consequences of monetary policy, providing new insights into how central banks can optimally balance inflation stabilization with inequality concerns.
A nuanced approach to policy
This study offers a crucial perspective on modern monetary policy, moving beyond simplistic models to address real-world household complexities.
Its finding that divergent rate movements can be optimal challenges conventional wisdom, suggesting central banks must consider distributional impacts more explicitly.
While the DSGE model provides a theoretical framework, practical implementation of such a nuanced yield curve control strategy would present significant operational challenges.