Monetary policy and earnings inequality: inflation dependencies

Summary

Focus

The post-pandemic surge in inflation emphasises the importance of studying the distributional consequences of monetary policy within a high-inflation environment. We assess the impact of monetary policy on labour income inequality, while considering the underlying inflation regime. Although recent studies have shown that monetary policy disproportionately affects labour income across the distribution, we investigate how these distributional effects vary depending on different inflation regimes. We then use our findings to assess how this channel influences aggregate dynamics, particularly focusing on the response of aggregate consumption.

Contribution

One major challenge in assessing the role of inflation and monetary policy transmission in labour income inequality lies in the limited availability of granular, high-frequency data. Using monthly administrative tax data from Estonia, a euro area member, we document a novel inflation-dependent pattern in the distributional effects of monetary policy. We also study the aggregate implications by enhancing our data set with granular estimates of the marginal propensity to consume. Finally, we develop a macroeconomic model with two distinct inflation regimes and built-in heterogeneity to provide a theoretical framework for interpreting our findings.

Findings

Our main finding is that inflation dependencies play an essential role in the distributional impact of monetary policy. Specifically, we find that monetary policy shocks have a substantial impact on labour income inequality in a high-inflation environment, whereas their effects on inequality are more muted in a low-inflation environment. When assessing the aggregate implications, we find that monetary policy shocks cause a considerably larger quantitative impact, as measured by the aggregate consumption response, when inflation is high. Our results highlight the importance of jointly accounting for heterogeneity in labour income and the inflation environment when studying the impact of monetary policy.

Abstract

This paper studies the distributional effects of monetary policy and its dependence on inflation. We document a novel dependency in the earnings heterogeneity channel of monetary policy using high-frequency, administrative tax data from eurozone member Estonia. Monetary policy shocks substantially influence earnings inequality during high-inflation periods, with weaker effects during low-inflation periods. Extending our dataset with granular MPC estimates, we show that earnings heterogeneity amplifies the aggregate MPC and consumption response. In high-inflation periods, consumption and inequality respond more, even though the aggregate MPC may be lower. We rationalise our findings with a nonlinear tractable HANK model featuring inflation dependencies.

JEL classification: E52, D31, J31, J63

Keywords: monetary policy, labour income inequality, inflation, state dependency, earnings heterogeneity channel, aggregate MPC