ESSAYS ON MONETARY POLICY AND HOUSEHOLD INEQUALITY

Abstract

A central question in monetary economics is how changes in monetary policy affect economic activity. Three major changes in the U.S. economy are currently reshaping the academic debate surrounding this classic question. First, inequality in the United States has risen significantly in recent decades. Second, the Great Recession and the recent pandemic crisis pushed the nominal policy rate to effective lower bound (ELB), and consequently, the Federal Reserve resorted to unconventional monetary policies, such as quantitative easing (QE). Third, a secular decline has pushed real interest rates to levels close to zero, and in response, academia proposed an increase in the inflation target. Each of these developments motivates a chapter of my dissertation. The first chapter of my dissertation develops a state-of-the-art heterogeneous agent monetary model and studies the transmission mechanisms and the distributional consequences of conventional monetary policy. Compared to the existing models in the literature, the model exhibits the responses of real wages and profits to monetary policy shocks that are consistent with the existing empirical evidence. With the model parameterized to match the distribution of wealth and income in the United States, I first examine how an unexpected decrease in the nominal interest rate leads to an increase in aggregate consumption. My analysis shows that most of the consumption response is due to general equilibrium income effects rather than inter-temporal substitution, consistent with the existing results in the literature. However, when wages are rigid and profits are procyclical, as in the data, consumption responses are stronger at both ends of the wealth distribution, unlike in the standard model with flexible wages. Importantly, an expansionary monetary policy shock can increase inequality by inducing higher profits and equity prices, though it benefits households at the bottom significantly by reducing unemployment risks, as opposed to the existing results in the literature. This second chapter studies how quantitative easing (QE) affects household welfare across the wealth distribution. To this end, the model developed in the first chapter is extended to feature frictional financial intermediation, an effective lower bound (ELB) on the policy rate, forward guidance, and QE. Moreover, to quantify the contribution of the various channels through which monetary policy affects inequality, I estimate the model using Bayesian methods, explicitly taking into account the occasionally binding ELB constraint and the QE operations undertaken by the Federal Reserve during the 2009-2015 period. I find that QE program unambiguously benefited all households by stimulating economic activity. However, it had non-linear distributional effects. On the one hand, it widened the income and consumption gap between the top 10% and the rest of the wealth distribution, by boosting profits and equity prices. On the other hand, QE shrank inequality within the lower 90% of the wealth distribution, primarily by lowering unemployment. On net, it reduced overall wealth and income inequality, as measured by the Gini index. Surprisingly, QE has weaker distributional consequences compared with conventional monetary policy. Lastly, forward guidance and an extended period of zero policy rates amplified both the aggregate and the distributional effects of QE. The third chapter of my dissertation investigates the aggregate and the distributional consequences of raising the inflation target from 2% to 4% using the model developed and estimated in the second chapter. I find that, during the transition towards the 4% inflation target, the economy experiences substantial expansion because of the forward-looking Phillips curve and the Taylor rule that features a significant degree of interest rate smoothing. Also, the transition reduces the overall degree of inequality by lowering the unemployment rate and the real interest rate though it leaves bigger welfare gains for the top than for the middle. During the simulation around the new steady-state with the 4% inflation target, both frequency and duration of the ELB episodes are lower. Importantly, the average unemployment rate and its standard deviation are significantly lower with the higher inflation target, which leads to higher aggregate demand and lower overall inequality on average.