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Household Heterogeneity and the Performance of Monetary Policy Frameworks

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Although inflation targeting (IT) has been keeping inflation low and stable over the past several decades, two leading and persistent trends raise the question of how well IT performs compared with other alternative monetary policy frameworks. On one hand, interest rates are on a path that has been  declining persistently, which could increase the chances of the economy getting stuck in a low interest rate environment. On the other hand, inequality has been rising in major developed economies since the 1980s. This could amplify the impact of a recession by affecting poor households more than their wealthier counterparts. Despite the importance of both trends, the interacting implications they may have on different frameworks are not fully understood.

Motivated by these observations, we study the ranking of monetary policy frameworks that consider  inequality and a low interest rate environment. We use a macroeconomic model that reflects some key elements of income risk in Canada. This model reveals that a trade-off exists between low and stable inflation and higher consumption inequality.

First, we find that price-level targeting (PLT) is relatively better than other alternative policies at stabilizing business cycles. Second, we show that the performance of PLT deteriorates compared with average inflation targeting (AIT) and IT if the central bank places a large weight on consumption inequality. This is because PLT generates additional volatility in output to bring the price level back to target. Volatile output leads directly to larger fluctuations in consumption inequality. And third, we find that the presence of a low interest environment does change the above results.