Abstract
I characterize optimal government policy in a sticky-price economy with
different types of consumers and endogenous financial constraints in the
banking and entrepreneurial sectors. The competitive equilibrium allocation is
constrained inefficient due to a pecuniary externality implicit in the
collateral constraint and other externalities arising from consumer type
heterogeneity. These externalities can be corrected with appropriate fiscal
instruments. Independently of the availability of such instruments, optimal
monetary policy aims to achieve price stability in the long run and approximate
price stability in the short run, as in the conventional New Keynesian
environment. Compared to the competitive equilibrium, the constrained efficient
allocation significantly improves between-agent risk sharing, approaching the
unconstrained Pareto optimum and leading to sizable welfare gains. Such an
allocation has lower leverage in the banking and entrepreneurial sectors and is
less prone to the boom-bust financial crises and zero-lower-bound episodes
observed occasionally in the decentralized economy.