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 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 low-inequality states.