Optimal Monetary Policy According to HANK

We study optimal monetary policy in an analytically tractable Heterogeneous Agent New Keynesian (HANK) model with rich cross-sectional heterogeneity in income, wealth and consumption. In such an economy, a central bank has an incentive to reduce consumption inequality in addition to keeping inflation stable and economic activity at its efficient level. These are the central bank’s only objectives in the standard Representative Agent New Keynesian (RANK) model.

Our framework allows monetary policy to affect both within-group and between-group. As in RANK, optimal monetary policy can be thought of as a form of flexible price level targeting. However, a concern for inequality leads the monetary policy-maker to put more weight on stabilizing the level of economic activity and correspondingly less weight on stabilizing prices.

Importantly, a central bank that cares about inequality does not need to explicitly include a measure of inequality in its reaction function—placing a higher weight on stabilizing economic activity is sufficient.