By Galo Nuño and Carlos Thomas
http://d.repec.org/n?u=RePEc:bde:wpaper:1624&r=dge
Incomplete markets models with heterogeneous agents are increasingly used for policy analysis. We propose a novel methodology for solving fully dynamic optimal policy problems in models of this kind, both under discretion and commitment. We illustrate our methodology by studying optimal monetary policy in an incomplete-markets model with non-contingent nominal assets and costly inflation. Under discretion, an inflationary bias arises from the central bank’s attempt to redistribute wealth towards debtor households, which have a higher marginal utility of net wealth. Under commitment, this inflationary force is countered over time by the incentive to prevent expectations of future inflation from being priced into new bond issuances; under certain conditions, long run inflation is zero as both effects cancel out asymptotically. For a plausible calibration, we find that the optimal commitment features first-order initial inflation followed by a gradual decline towards its (near zero) long-run value. Welfare losses from discretionary policy are first-order in magnitude, affecting both debtors and creditors.
This is an interesting paper for two reasons. First, it provides an new solution method. Second, the application yields substantial welfare costs for inflation. It would be really useful to see someone replicate this with another method to verify that the result is not driven by the method.
NEP-DGE Blog 
This is a great paper that shows how to compute optimal monetary policy in a Huggett type framework — both under discretion and under commitment. The authors find an interesting inflationary bias of discretionary policy in order to redistribute wealth to borrowing agents with high marginal utility of wealth. I think it would be interesting to include nominal rigidities and a zero lower bound to see how that affects the finding of deflationary bias of discretionary policy found e.g. in Nakov (2008). Also interesting would be to find out the effects of non-conventional policies such as asset purchases or helicopter drops of money as a way of getting out of a deep recession.
Thanks a lot to Christian Zimmerman for his entry on our paper. Anton, thanks a lot too for your comment. Indeed, it would be interesting to extend our analysis to a framework that includes nominal rigidities and possibly a binding ZLB. As regards nominal rigidities, notice nonetheless that the functional form for the welfare cost of inflation used in our numerical analysis can be rationalized on the basis of quadratic price adjustment costs à la Rotemberg (1982), as we show in the Appendix.