Heterogeneity, Bubbles and Monetary Policy

Using a tractable New Keynesian model with heterogeneous agents, we analyze the interplay between households' heterogeneity and rational bubbles, and their normative implications for monetary policy. Households are infinitely-lived and heterogeneous because of two sources of idiosyncratic uncertainty, which makes them stochastically cycle in and out of segmented asset markets, and in and out of employment. We show that bubbles can emerge in equilibrium despite the fact that households are infinitely lived, because of the structural heterogeneity that affects their activity in asset and labor markets. The elasticity of an endogenous labor supply, the heterogeneity in asset-market participation and the level of long-run monopolistic distortions are shown to affect the size of equilibrium bubbles and their cyclical implications. We also show that a central bank concerned with social welfare faces an additional tradeoff implied by bubbly fluctuations which makes, in general, strict inflation targeting a suboptimal monetary-policy regime.