Income Inequality, Financial Crises and Monetary Policy

Isabel Cairo and Jae Sim
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Jae Sim: Federal Reserve Board

No 1433, 2017 Meeting Papers from Society for Economic Dynamics

Abstract: We construct a general equilibrium model in which income inequality results in insufficient aggregate demand and deflation pressure by allocating a greater share of national income to a group with the least marginal propensity to consume, and if excessive, can lead to an endogenous financial crisis. The effectiveness of monetary policy during financial crises is severely distorted by the zero lower bound (ZLB) constraint. Such an economy generates left-skewed distributions for equilibrium prices and quantities, creating disproportionately large downside risks. Consequently, symmetric monetary policy rules that are designed to minimize the fluctuations in equilibrium quantities and prices around fixed means become inefficient. We evaluate alternative monetary policy rules in their ability to minimize not only the variance but also the skewness of the target variable. We find that a type of forward guidance rule of promising to lower the long-run natural rate of interest persistently in response to crises may bring large welfare gains by correcting the skewness of the distributions and thus increasing the means of aggregate output and inflation. While we assume no direct preferences of central bankers over income inequality, monetary policy rules correcting the skewed distributions also lessen the degree of income inequality substantially as low income households suffer the most from the asymmetric macroeconomic risks.

Date: 2017
New Economics Papers: this item is included in nep-dge, nep-mac and nep-mon
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Citations: View citations in EconPapers (5)

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Working Paper: Income Inequality, Financial Crises, and Monetary Policy (2018)
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