Expenditure Elasticity and Inequality Over the Business Cycle

Abstract

I analyze a new channel through which real labor income inequality can vary over the business cycle arising from heterogeneity in the households exposure to different sectors in their consumption and labor choices. This heterogeneous exposure has two sources of origin both are empirically documented in this paper. First, low income households consume less from sectors with high expenditure elasticity and are therefore less exposed to fluctuations in their prices. Second, low income households tend to work more in service occupations that are used most intensely in sectors with high expenditure elasticity and are therefore more exposed to labor demand fluctuation in these sectors. While the mechanism is relevant to any shock that increases income, I focus my analysis on monetary policy shocks that are reliably identified using high frequency data. In my analysis I establish that as a response to a monetary policy shock the aggregate value added share of sectors with high expenditure elasticity increases. This implies an increase in:

(1) the relative prices of goods or services in these sectors

(2) the relative income share of employees in these sectors.

Both effects result in an increase in the relative real wage of low income households that are less exposed to the increase in prices while more exposed to the increase in wages. I use a TANK model with non-homothetic preferences and sector heterogeneity to quantify the effects of this mechanism and evaluate how it has change over time with changes in sectoral and occupational composition.