Monetary Policy, Income Inequality, and Inflation — What’s the Link?

Abstract

This paper studies the link in Canada between monetary policy, income inequality, and inflation. What are the effects of monetary policy on income inequality? and why and how does inflation play a role? Income inequality largely increased from the time the Bank of Canada began targeting inflation, through the late 1990s to the early 2000s, and flattened or decreased after the 2008 financial crisis. On the whole, income inequality today is greater than it was when the Bank of Canada became an inflation-targeting central bank. Against this backdrop, our analysis shows that expansionary monetary policy shocks, triggered by a lower than expected bank rate, lead to increasing income inequality, while contractionary monetary policy shocks reduce income inequality. We then show that these effects are asymmetric with expansionary shocks having a greater impact on income inequality than contractionary shocks. Expansionary monetary policy shocks result in a higher share of national income shifting to higher income households, who consume less as a percentage of their income, dampening the increase in aggregate demand, and, therefore, inflation. Our results lead to one particularly important conclusion for monetary policy: namely, that the Bank of Canada needs to account for the impact of income inequality when modeling how inflation will respond to a change in the overnight rate.