We consider an incomplete-markets economy with capital accumulation and endogenous labor supply. Individuals face countercyclical idiosyncratic labor and asset risk. We derive conditions under which the aggregate allocations and price system can be found by solving a representative agent problem. This result is applied to analyze the properties of an optimal monetary policy in a new Keynesian economy with uninsured countercyclical individual risk. The optimal monetary policy that emerges from our incomplete-markets economy is the same as the optimal monetary policy in a representative agent model with preference shocks. When price rigidity is the only friction, the optimal monetary policy calls for stabilizing the inflation rate at zero.
JEL classification: D52, E32, E52
Key words: uninsured risk, sticky prices, optimal monetary policy
The authors thank three referees and the editor, Fabio Canova, for their very helpful comments. We also wish to thank Jordi Galí, Ippei Fujiwara, Shiba Suzuki, participants at the CEPR-RIETI conference in 2008, Canon Institute of Global Studies conference in 2010, and seminar participants at the Bank of Japan, and Singapore Management University for helpful comments. Braun and Nakajima acknowledge financial support from the Japanese Ministry of Education, Culture, Sports, Science and Technology. The views expressed here are the authors' and not necessarily those of the Federal Reserve Bank of Atlanta or the Federal Reserve System. Any remaining errors are the authors' responsibility.
Please address questions regarding content to R. Anton Braun, Research Department, Federal Reserve Bank of Atlanta, 1000 Peachtree Street, N.E., Atlanta, GA 30309-4470, 404-498-8708, 404-498-8956 (fax), email@example.com, or Tomoyuki Nakajima, Institute of Economic Research, Kyoto University, Kyoto 606-8501, Japan, +81-(0)75-753-7132, +81‑(0)75-753-7138 (fax), firstname.lastname@example.org.
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