Monetary Policy Transmission with Income Risk

Abstract

Since the 1970s, income risk faced by households has increased and monetary policy transmission has become weaker. I investigate the role of income risk in weakening monetary policy transmission. I first show analytically that increased income risk weakens the substitution effect of interest rate changes but amplifies the income effect from wage changes. The first channel dominates the latter, thus higher income risk weakens monetary policy transmission. Second, I assess the impact income risk has on monetary policy transmission in a heterogeneous-agent New-Keynesian model. The increase in income risk since the 1970s weakens monetary policy transmissions to consumption by 5 %.