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Income Inequality, Financial Crises and Monetary Policy

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  • Isabel Cairo

    (Board of Governors of the Federal Reserve System)

  • Jae Sim

    (Federal Reserve Board)

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.

Suggested Citation

  • Isabel Cairo & Jae Sim, 2017. "Income Inequality, Financial Crises and Monetary Policy," 2017 Meeting Papers 1433, Society for Economic Dynamics.
  • Handle: RePEc:red:sed017:1433
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    3. Sandra Eickmeier & Benedikt Kolb & Esteban Prieto, 2018. "Effects of bank capital requirement tightenings on inequality," CAMA Working Papers 2018-43, Centre for Applied Macroeconomic Analysis, Crawford School of Public Policy, The Australian National University.
    4. François Gourio & Anil K. Kashyap & Jae W. Sim, 2018. "The Trade offs in Leaning Against the Wind," IMF Economic Review, Palgrave Macmillan;International Monetary Fund, vol. 66(1), pages 70-115, March.

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    JEL classification:

    • E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • G01 - Financial Economics - - General - - - Financial Crises

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