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Uninsured Unemployment Risk and Optimal Monetary Policy in a Zero-Liquidity Economy

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  • Edouard Challe

Abstract

I study optimal monetary policy in a sticky-price economy wherein households precautionary-save against uninsured, endogenous unemployment risk. In this economy greater unemployment risk raises desired savings, causing aggregate demand to fall and feed back to greater unemployment risk. This deflationary spiral is constrained inefficient and calls for an accommodative monetary policy response: after a contractionary aggregate shock the policy rate should be kept significantly lower and for longer than in the perfect-insurance benchmark. For example, the usual prescription obtained under perfect insurance of a hike in the policy rate in the face of a bad supply (i.e., productivity or cost-push) shock is easily overturned. The optimal policy breaks the deflationary spiral and takes the dynamics of the imperfect-insurance economy close to that of the perfect-insurance benchmark. These results are derived in an economy with zero asset supply (zero liquidity) and are thus independent of any redistributive effect of monetary policy on household wealth.

Suggested Citation

  • Edouard Challe, 2020. "Uninsured Unemployment Risk and Optimal Monetary Policy in a Zero-Liquidity Economy," American Economic Journal: Macroeconomics, American Economic Association, vol. 12(2), pages 241-283, April.
    • Handle: RePEc:aea:aejmac:v:12:y:2020:i:2:p:241-83
    DOI: 10.1257/mac.20180207
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    More about this item

    JEL classification:

    • E21 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Consumption; Saving; Wealth
    • E24 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Employment; Unemployment; Wages; Intergenerational Income Distribution; Aggregate Human Capital; Aggregate Labor Productivity
    • E31 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Price Level; Inflation; Deflation
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • G51 - Financial Economics - - Household Finance - - - Household Savings, Borrowing, Debt, and Wealth

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