Optimal Monetary Policy during a Cost-of-Living Crisis

Abstract:

How should monetary policy react to aggregate and sectoral disruptions in a world in which consumption baskets and hence inflation rates vary across households? We present a multi-sector New Keynesian with generalized, non-homothetic preferences and realistic heterogeneity in wealth, income, and consumption of different goods. Despite its richness, the model is computationally tractable. We highlight two novel wedges emerging in the New Keynesian Phillips Curve, which fluctuate with the distribution of consumption expenditures. We find that these wedges can have profound implications for the joint dynamics of inflation and the output gap, and hence policy trade-offs. Moreover, shocks and policy changes are found to have vastly heterogeneous effects on different households. Finally, we show that there is no universally optimal policy response to distinct sectoral supply shocks, as the appropriate policy reaction  can depend strongly on whether the shock originates in a luxury or a necessity sector.