Optimal Monetary Policy for the Masses

July 17, 2025
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Abstract

We study nominal GDP targeting as optimal monetary policy in a simple and stylized model with a credit market friction. The macroeconomy we study has considerable income inequality, which gives rise to a large private sector credit market. This is an important credit market friction because households participating in the credit market use non-state-contingent nominal contracts (NSCNC). We extend previous results in this model by allowing for substantial intra-cohort heterogeneity, which is substantial enough that we can approach measured Gini coefficients for income, financial wealth, and consumption in the U.S. data. We show that nominal GDP targeting continues to characterize optimal monetary policy in this setting. Optimal monetary policy repairs the distortion caused by the credit market friction, thereby leaving heterogeneous households supplying their desired amount of labor, a type of “divine coincidence” result. We also further characterize monetary policy in terms of nominal interest rate adjustment.


Income Inequality and Monetary Policy

Can monetary policy be conducted in a way that benefits all households in a world with substantial heterogeneity? Does monetary policy have an important impact on the distribution of consumption, income, and financial wealth among heterogeneous households? The spirit of many modern models of monetary policy is that such questions can be pushed into the background via an assumption of a representative household, at least if one is primarily interested in studying only the aggregate implications of monetary policy. However, recent heterogeneous-agent models of monetary policy surveyed by Galí (2018, p. 102) seem to “argue that the representative household assumption is less innocuous [than] it may appear.”

In this article we build a simple and stylized model with substantial heterogeneity to help provide some perspective on these questions. We follow recent work by Sheedy (2014), Koenig (2013), Azariadis et al. (2019), and Bullard and Singh (2020). These papers all provide analyses of economies where the household credit market plays a key role and where that market is subject to a friction: non-state-contingent nominal contracting (NSCNC). Optimal monetary policy is characterized as a version of nominal GDP targeting, and the role of monetary policy is to provide a type of insurance to private sector credit markets.

We also scale up the natural household heterogeneity ordinarily present in this model to begin to approach the Gini coefficients in the U.S. data corresponding to the actual degree of income, financial wealth, and consumption inequality. We do this in a way that maintains the simple and stylized structure of the model so that the equilibrium can still be calculated with “pencil and paper” methods, even in the presence of an aggregate shock and a rich net asset-holding distribution.

More specifically, we construct a (T + 1)-period general equilibrium life-cycle framework with heterogeneous households. Agents have homothetic preferences defined over consumption and leisure choices and are randomly assigned any one of a continuum of possible productivity profiles as they enter the economy. This random assignment creates substantial intra-cohort heterogeneity in addition to the inter-cohort heterogeneity emphasized in previous papers. We keep this increased heterogeneity manageable by indexing it to a single parameter, allowing for the complete characterization of optimal monetary policy even in this case.

Our main finding is that nominal GDP targeting continues to characterize the optimal monetary policy in the economy with the “massive” heterogeneity as we have introduced it. The key aspect of policy continues to be countercyclical price-level movements. The optimal monetary policy repairs the distortion caused by the NSCNC friction: Despite the substantial heterogeneity, all households benefit from smoothly operating credit markets. In the equilibrium we study, households with the same life-cycle productivity will consume the same amount at each date, a version of the hallmark result in this literature that credit markets under optimal policy are characterized by “equity share” contracting. Equity share contracting is known to be optimal when preferences are homothetic.

ABOUT THE AUTHORS
James Bullard

James Bullard served as president and CEO of the Federal Reserve Bank of St. Louis from April 1, 2008, to July 13, 2023. In this capacity, he oversaw the activities of the Eighth Federal Reserve District and was a participant on the Federal Open Market Committee. More about Bullard.

James Bullard

James Bullard served as president and CEO of the Federal Reserve Bank of St. Louis from April 1, 2008, to July 13, 2023. In this capacity, he oversaw the activities of the Eighth Federal Reserve District and was a participant on the Federal Open Market Committee. More about Bullard.

Riccardo DiCecio

Riccardo DiCecio is an economic policy advisor and special assistant to the Bank president at the Federal Reserve Bank of St. Louis. His main areas of research interest are empirical macroeconomics and time series econometrics.

Riccardo DiCecio

Riccardo DiCecio is an economic policy advisor and special assistant to the Bank president at the Federal Reserve Bank of St. Louis. His main areas of research interest are empirical macroeconomics and time series econometrics.

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Editors in Chief
Michael Owyang and Juan Sanchez

This journal of scholarly research delves into monetary policy, macroeconomics, and more. Views expressed are not necessarily those of the St. Louis Fed or Federal Reserve System. View the full archive (pre-2018).


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