The Very Model of Modern Monetary Policy

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New class of quantitative models, HANK models, combine heterogeneous agent models with New Keynesian models to center wealth and income distributions in monetary analysis.
HANK models help interpret empirical observations, measure strengths of forces affecting inflation and output, and assess trade-offs between competing monetary policy objectives.
Traditional models ignore income and wealth inequalities and assume what’s good for the typical consumer is good for the broader economy; HANK models challenge this assumption.

Monetary policy affects household consumption through direct channels (changes in short-term policy rates affecting willingness to postpone purchases) and indirect channels (effects on long-term bond and mortgage rates, asset prices, dividends, wages, taxes, and transfers).
The relative importance of indirect versus direct channels depends mainly on the aggregate marginal propensity to consume (MPC).
Traditional models imply a tiny MPC and insignificant indirect channels; HANK models are built to match empirical consumption/saving behavior and have an aggregate MPC that is roughly 10 times larger, making indirect effects dominant.
Implications for central banks:
- Need detailed information on the distribution of MPCs, income sources, and household balance sheets.
- Must understand market structures and frictions that contribute to price formation in goods, inputs, credit, housing, and financial markets, and institutions such as local governments, unions, and regulatory bodies.

The “rising tide raises all ships” view is a fiction according to HANK models.
Monetary policy generates heterogeneous effects across households:
- Rate cuts benefit debtors (lower interest payments, e.g., adjustable-rate mortgages) and hurt savers (lower interest income).
- Inflation benefits households with large nominal debt (real value of debt falls).
- Price changes differ across consumption baskets; households consuming more of goods with larger price increases are more harmed.
- Indirect effects on disposable income vary with households’ exposure to aggregate activity.
Redistribution is central to monetary transmission: when resources move from low-MPC households to high-MPC households (savers to spenders), policy impacts on macro aggregates are amplified.
Redistributive effects vary across countries and are likely stronger in countries with high poverty or high inequality, implying different monetary transmission between advanced economies and low- and middle-income countries.
HANK models imply stabilization and redistribution cannot be cleanly separated.

HANK models reestablish a strong link between monetary and fiscal policy: monetary policy leaves consequential “fiscal footprints.”
When central banks raise interest rates, treasury borrowing costs increase, requiring either higher taxes, lower expenditures (now or later), or future inflation to fund the shortfall.
How and when the government finances higher borrowing costs, and which households bear the burden, greatly influence the overall effects of interest rate hikes.
The fiscal footprint generates additional redistribution that can amplify or dampen monetary shocks depending on direction (from savers to spenders or vice versa).
The more government debt and the shorter its maturity, the larger the fiscal footprint.
HANK models provide a natural framework to study fiscal policy effects on productive efficiency, social insurance, and redistribution.

Studies of optimal monetary and fiscal policy in HANK models find gains from direct redistribution toward those in hardship dwarf benefits from aggregate stabilization.
Optimal policies in HANK models almost always favor redistributing toward hand-to-mouth households in downturns.
Monetary policy is a blunt instrument for redistribution or insurance; fiscal policy can be targeted more precisely and is likely better suited for alleviating hardship.

The macro impact of a shock on aggregate spending is larger when individual MPCs and individual exposures to the shock are more strongly correlated.
Redistributive implications of inflation across households are crucial to gauge aggregate implications:
- Poor families spending a larger share on basic goods like energy are especially harmed.
- Borrowers gain as the real value of their debt falls; households with large cash or liquid savings lose.
- Workers with flexible compensation (bonuses, commissions) can limit loss of purchasing power; workers with infrequently negotiated nominal wages or paid minimum wage see real earnings shrink.
Level and distribution of household savings matter:
- Excess savings from pandemic consumption restrictions are largely held by the well-off and are being spent at a very low rate.
- Excess savings from large government transfer programs in 2020 and 2021 are largely held by low-income households and are being spent much faster, sustaining aggregate demand and complicating central banks’ efforts to tame inflation.
A full welfare evaluation of current inflation must consider its causes: supply shocks (COVID-19 pandemic and war in Ukraine), large fiscal stimulus in 2020 and 2021, and loose monetary policy in the decade since the most recent recession. Each factor had redistributive components and heterogeneous effects that traditional models cannot capture.

Central banks need richer microeconomic data: distributions of MPCs, income sources, balance sheets, and exposure patterns across households.
Understand market structures, frictions, and institutions that mediate indirect transmission channels.
Coordinate monetary and fiscal policy recognizing fiscal footprints of monetary actions; consider maturity and size of public debt.
Use fiscal policy for targeted redistribution and insurance, while recognizing monetary policy’s limits as a redistributive tool.
Apply HANK models to interpret current inflation dynamics and design policies that account for heterogeneous household impacts.

F&D Magazine, “The Very Model of Modern Monetary Policy,” Greg Kaplan; BENJAMIN MOLL; GIOVANNI L. VIOLANTE, March 2023.