Unconventional policy and idiosyncratic risk

Within a New Keynesian model with heterogeneous households and credit frictions, we show that idiosyncratic uncertainty gives rise to an additional transmission channel that amplifies the effects of balance-sheet policies through consumption risk, making them a key tool for anchoring private-sector expectations. We further show that the optimal monetary policy features a clear division of labor between conventional and unconventional tools: balance-sheet policy should target cross-sectional welfare objectives, absorbing fluctuations in variables with distributional relevance such as private debt, whereas conventional interest-rate policy stabilizes aggregate targets and responds to aggregate shocks, as in the representative-agent benchmark. Thus, the optimal response to a debt-deleveraging crisis is unconventional: it entails a shorter, rather than longer, duration of zero-interest-rate policies relative to conventional inflation targeting, and does not require front-loaded inflation at the effective lower bound.