Financial constraints, risk sharing, and optimal monetary policy

Abstract: I characterize optimal government policy in a sticky-price economy with different types of consumers and endogenous financial constraints in the banking and entrepreneurial sectors. The competitive equilibrium allocation is constrained inefficient due to a pecuniary externality implicit in the collateral constraint and other externalities arising from consumer type heterogeneity. These externalities can be corrected with appropriate fiscal instruments. Independently of the availability of such instruments, optimal monetary policy aims to achieve price stability in the long run and approximate price stability in the short run, as in the conventional New Keynesian environment. Compared to the competitive equilibrium, the constrained efficient allocation significantly improves between-agent risk sharing, approaching the unconstrained Pareto optimum and leading to sizable welfare gains. Such an allocation has lower leverage in the banking and entrepreneurial sectors and is less prone to the boom-bust financial crises and zero-lower-bound episodes observed occasionally in the decentralized economy.