Uninsured Unemployment Risk and Optimal Monetary Policy
AbstractI study optimal monetary policy in a New Keynesian economy wherein house-
holds precautionary-save against uninsured, endogenous unemployment risk. In this economy greater unemployment risk raises desired savings, causing aggregate demand to fall and feed back to greater unemployment risk. I show this deationary feedback loop to be constrained-inefficient and to call for an accommodative monetary policy response: after a contractionary
aggregate shock the policy rate should be kept signi cantly lower and for longer than in the perfect-insurance benchmark. For example, the usual prescription obtained under perfect insurance of a hike in the policy rate in the face of a bad supply (i.e., productivity or cost-push) shock is easily overturned. If implemented, the optimal policy e¤ectively breaks the deflationary feedback loop and takes the dynamics of the imperfect-insurance economy close to that of the perfect-insurance benchmark.