Household inflation heterogeneity and the relative price elasticity channel of monetary policy

This paper shows that considerable differences in inflation rates exist among households in the United States. Against this background, we theoretically show that a central bank that considers household inflation heterogeneity can stabilize overall inflation more effectively. Using a tractable, multi-sector New Keynesian model with a low- and a high-income household, we show that a central bank that reacts to the inflation rate of the household less affected by price changes can achieve lower deviations of all households’ inflation rates from their steady states. The reason is that a weaker central bank reaction dampens an adverse relative price elasticity channel of monetary policy, allowing for more favorable relative price adjustments. The strength of this channel depends on household heterogeneity. • US households experience significantly different inflation rates over time. • Considering inflation differentials is beneficial for stabilizing overall inflation. • Reacting to households less affected by inflation stabilizes all inflation rates. • This stabilization is due to a relative price elasticity channel of monetary policy. • Household heterogeneity determines the strength of this channel.