Monetary Policy and Inequality: How Does One Affect the Other?

Abstract

This study investigates the relation between monetary policy and inequality by asking how one affects the other: the effect of monetary policy on inequality and the impact of the long-run level of inequality on the effectiveness of monetary policy. To this end, I incorporate nominal wage contracts and cash-in-advance constraints into a heterogeneous agent model economy with indivisible labor. I find that expansionary monetary policy reduces income, wealth, and consumption inequalities mainly due to a rise in employment from the bottom of the distributions. There are heterogeneous effects on income across the wealth distribution: in response to an unanticipated monetary easing, households in the bottom of the wealth distribution benefit from an increase in employment while rich households benefit from a rise in the real asset returns in a relative sense. An unexpected monetary expansion also has asymmetric responses of consumption between the poor and the rich: asset-poor households increase their consumption while it falls for wealthy households. This implies that inflation hurts the rich more. I also find that the long-run prevailing levels of inequality matter for the effectiveness of monetary policy by determining the size of labor supply elasticity, which represents the shape of reservation wage distribution. All else being equal, a more equal economy is associated with more effective monetary policy in terms of output. I also provide empirical evidence for this model result using state-level panel data: the effects of monetary policy shocks on output are larger for lowinequality states.

Inequality-constrained monetary policy in a financialized economy

“…Although not many, there are some contributions analyzing the opposite relationship, that is how inequality affects monetary policy. Ma (2019) studies the relationship between income inequality and the effectiveness of the monetary policy, focusing on the aggregate labor supply elasticity. According to Ma (2019), a less dispersed income distribution is associated with a larger aggregate labor supply elasticity, therefore the monetary policy can more effectively stabilize output when operating in low inequality economies.…”

“…Ma (2019) studies the relationship between income inequality and the effectiveness of the monetary policy, focusing on the aggregate labor supply elasticity. According to Ma (2019), a less dispersed income distribution is associated with a larger aggregate labor supply elasticity, therefore the monetary policy can more effectively stabilize output when operating in low inequality economies. Cairó and Sim (2018) argue that income inequality influences two traditional FED targets: inflation and financial fragility.…”