Financial development, income inequality, and the redistributive effects of monetary policy

How should financial systems be designed to limit income inequality? Does the redistributive impact of inflation depend on the extent of financial development? Should optimal monetary policy vary across countries with different levels of financial development? In order to address these questions, we develop a monetary growth production model with heterogeneous agents. In our economy, optimal policy needs to weigh the effects of policy across two groups – capital owners and individuals who hold liquid assets. In this environment, we compare various economies that are identical in every aspect except for their level of financial development. Interestingly, we generally find that economies at the highest stages of financial development (economies in which money, bonds, and claims to capital are traded) experience the highest amount of capital formation and social welfare as long as inflation is low. Yet, regardless of the extent of financial development, there are generally redistributive consequences from inflation. Moreover, the model tends to predict that economies with relatively small stock markets produce the highest levels of income inequality. Empirical work examining the role of money growth and the implications of financial development across countries is consistent with predictions from the model.