This paper studies the role of household heterogeneity in the severity of sudden stops crises and its implications for prudential capital control policy. I use data on sudden stop events and on financial market participation to document that a lower level of financial market participation is associated with a higher drop in asset prices. To explain the role that financial market participation plays in the drop in asset prices, I build an equilibrium business cycle model with a collateral constraint and with limited financial market participation. The heterogeneity in the accessibility to the financial market generates income and consumption inequality in the model. The extent to which the limited financial market participation amplifies the drop in asset prices depends on the cyclicality of consumption inequality. Consistent with my empirical findings using household survey data from Mexico, the model generates a drop in consumption inequality during the financial crisis that amplifies the drops in asset prices, output, and consumption. I also show that the optimal time-consistent debt is higher in a limited financial market participation economy, which rationalizes the use of capital control in emerging markets. Finally, my findings suggest that it is possible to address financial instability without raising inequality.
Can a Two-Agent New Keynesian model, also known as TANK, approximate a Heterogeneous Agents New Keynesian (HANK) model in terms of its aggregate response to a monetary policy shock? In this paper, I show that the answer depends on the source of nominal rigidities. If prices are sticky, the answer is yes, as shown by Debortoli and Gali (2018). If wages are sticky, the answer is no, as shown in this paper. To make this point, I show that the TANK model with only wage rigidities is equivalent, in terms of aggregate variables, to the representative agent New Keynesian model. For TANK with both price and wage rigidities, I show numerically that TANK does not approximate HANK well.
This paper examines the joint design of monetary policy and capital controls in an environment with a motive for both financial stability and price stability. I build an equilibrium business cycle model with a current-price collateral constraint, household heterogeneity due to a limited financial market participation, and nominal rigidity. I show that, in the absence of credit frictions (i.e., the collateral is never binding), the monetary authority under the discretionary monetary policy has an incentive to deviate implementing price stability (the divine coincidence does not hold). In addition, I show that in the case of financial instability due to credit frictions, the monetary authority under the discretionary monetary policy should adopt a prudential monetary policy only if capitals flows are free. This prudential monetary polic is exacerbated by household inequality. In the absence of a working capital loan procyclical monetary policy is never optimal.