Limited Asset Market Participation and the Optimal Fiscal and Monetary Policies

By Lorenzo Menna and Patrizio Tirelli

http://d.repec.org/n?u=RePEc:mib:wpaper:284&r=dge

In the workhorse DSGE model, the optimal steady state inflation rate is near to zero or slightly negative and inflation is almost completely stabilized along the business cycle (Schmitt-Grohé and Uribe, 2011). We reconsider the issue, allowing for agent heterogeneity in the access to the market for interest bearing assets. We show that inflation reduces inequality and that LAMP can justify relatively high optimal inflation rates. When we calibrate the share of constrained agents to fit the wealth Gini index for the US, the optimal inflation rate is well above 2%. The optimal response to shocks is also affected. Rather than using public debt to smooth tax distortions, the Ramsey planner front loads tax rates and reduces public debt variations in order to limit the redistributive effects of debt service payments.

Intriguing paper that, for once, does not rely on downward nominal price rigidities to justify positive inflation. It also implies that a little dose of debt monetization is to some extent justified. This has to get a few people thinking.