Household Debt and the Heterogeneous Effects of Forward Guidance

Abstract

We develop an incomplete-markets heterogeneous agent New-Keynesian (HANK) model in which households are allowed to lend and borrow, subject to a borrowing constraint. We show that, in this framework, forward guidance, that is the promise by the central bank to lower future interest rates, can be a powerful policy tool, especially when the economy is in a liquidity trap. In our model, the power of forward guidance is amplified by three redistributive channels, absent in a representative agent new-Keynesian model (RANK) or in a HANK model without private debt. First, expected lower rates imply a future transfer of wealth from savers to borrowers, reducing precautionary motives and stimulating current demand and inflation. Second, higher initial inflation lowers the path of the real rate increasing the wealth of borrowers, who have a higher marginal propensity to consume (MPC). Third, if debt is nominal, debt deflation generates also a wealth transfer towards high-MPC borrowing-constrained agents, further increasing aggregate consumption and inflation. These channels amplify each other in a liquidity trap, and can make forward guidance more powerful in a HANK model than in a RANK framework. These results contrast with previous research on HANK models, which focused on frameworks where agents were not allowed to borrow, and which found negligible effects of forward guidance.

On Household Labour Supply in Sticky-Wage HANK models

“…See alsoFerrante and Paustian (2019). This intuition is similar to the interest rate exposure channel discussed inAuclert et al (2023a).…”

Make-Up Strategies with Incomplete Markets and Bounded Rationality

“…For instance, redistributional effects that transfer wealth from low-MPC savers to high-MPC borrowers could in principle raise the potential of future interest rate cuts to provide economic stimulus (see e.g. Ferrante and Paustian, 2019). For our model, these counteracting forces appear to roughly cancel each other out, such that market incompleteness does not matter much for the effectiveness of make-up strategies.…”

“…10 Specifically, it contributes to recent studies 7 As in Hagedorn et al (2019), we consider a HANK model with nominal wage stickiness and a calibration that attenuates the power of anticipated future monetary accommodation, which AIT relies on. In contrast to these authors, we however allow for positive (nominal) household debt as in Ferrante and Paustian (2019), such that there are redistributive effects that can potentially increase the effectiveness of future interest rate changes by reallocating resources between indebted high-and saving low-MPC households.…”

“…For the RANK model, we normalise the labour disutility parameter χ to 1 and set it equal to 1.023 for the corresponding HANK model, such that both model versions display the same steady-state output level. The household borrowing limit is set to -1.667, which equals 5 times the monthly household labour income (seeFerrante and Paustian, 2019). We set the elasticity of substitution between in-27 It is of course possible to consider initial beliefs based on more general rational-expectations equilibria (see e.g Farhi and Werning, 2019)…”