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BOK Working Paper No.2019-9, Monetary Policy in a Two-Agent Economy with Debt-Constrained Households

Economic Research Institute (82-2-759-4177) 2019.02.19 3650

Title : Monetary Policy in a Two-Agent Economy with Debt-Constrained Households

Author : Yongseung Jung(KyungHee University), SungJu Song(BOK)


<Abstract>


This paper examines monetary policy quantitatively in a two-agent and small-scale New-Keynesian economy with debt-constrained households who cannot smooth their consumption intertemporally and frictionlessly since highly indebted households are not allowed to borrow above a certain debt ceiling in incomplete financial markets without additional risk premiums due to information asymmetry between savers and borrowers.

  We find that, in the event of cost shocks, the asymmetric responses of borrowing households without and saving households with dividend incomes lead to different labor supplies and consumptions over heterogeneous households, and eventually to an extension of monetary policy transmission channels. The income effect and low elasticity of labor supply play key roles for such asymmetric responses over heterogeneous households. We also find that the social welfare in flexible inflation targeting (FIT) monetary policy, in which both the inflation gap and output gap are considered in an integrated way for policy-making, is similar to that of Ramsey optimal monetary policy (ROP), in which the shares of debt-constrained households as well as all economic states including both the inflation gap and output gap are considered comprehensively for policy-making, and greater than that of simple inflation targeting (SIT) monetary policy, in which only the inflation gap is considered mechanically for policy-making. Such social welfare implies that FIT policy may still work well even in an economy with a sizable number of debt-constrained households. Further, the responses of cost shocks to consumption and labor supply are dying out more slowly in FIT and ROP policies than in SIT policy.

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