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

Abstract

This study investigates the relation between monetary policy and income inequality by asking how one affects the other: the effect of monetary policy on income inequality and the impact of the long-run level of income inequality on the effectiveness of monetary policy. To this end, I build a heterogeneous-agent New Keynesian economy with indivisible labor in which both macro and micro labor supply elasticities are endogenously generated. I find that monetary policy shocks have distributional consequences due to a substantial heterogeneity in labor supply elasticity across households. I also show that a more equal economy is associated with more effective monetary policy in terms of output since it generates a larger aggregate elasticity of labor supply, thereby having a flatter New Keynesian Philips curve. Empirical evidence based on state-level panel data supports this model result.