The Washington Center for Equitable Growth recently announced our Request for Proposals 2023 support research on the different channels through which economic inequality, in all its forms, may or may not impact economic growth and stability. A particular area of interest is monetary policy. Indeed, in recent years, policy makers and economists were interested in the distributive effects of monetary policy, in particular following the policies implemented after the 2008 global financial crisis.
More recently, in light of the current state of inflation, the economic recovery from the COVID-19 recession and the Federal Reserve Responsethere has been renewed interest in how monetary policy, both expansionary and restrictive, can affect economic inequality and growth. New search examines how monetary policy can affect inequalities between different types of workers and firms. As part of Equitable Growth Working Paper SeriesMartina Jasova of Barnard College and her co-authors provide new evidence on the heterogeneous effects of monetary policy on workers’ labor market outcomes and how effects on firms through the credit channel affect their wages .
Using a unique granular administrative dataset that matches linked data between employee and employer and credit registry at the loan level of companies in Portugal, Jasova and her co-authors find that a Expansionary monetary policy disproportionately improves labor market outcomes for workers in smaller and younger firms. The first benefit of expansionary monetary policy for workers in smaller, younger firms is wages. The co-authors find that following a 1 percentage point cut in the policy rate, workers in small firms experience a 1.16 percentage point increase in wages, relative to workers in large firms. In the same monetary policy scenario, workers in young firms experience a wage increase of 0.4 percentage points compared to old firms.
The co-authors also find that a 1 percentage point cut in the monetary policy rate reduces the wage gap between small and large firms by about 5%, and between young and old firms by about 4.4%. This is likely because expansionary monetary policy eases financial constraints that hit growing firms harder and therefore allows firms to raise the wages of their workers whose wages were previously retrocharged— that is, lower wages at the start of a job in exchange for higher wages later.
The second benefit of an expansionary monetary policy is employment. A 1 percentage point decline in the monetary policy rate is associated with a 1.73 percentage point increase in employment in small firms, relative to large firms, and a 2.16 percentage point increase in percentage of employment in young firms, compared to older firms. Taken together, the authors conclude that expansionary monetary policy further improves labor market outcomes in small and young firms and therefore reduces between-firm inequality in the economy.
Yet the distributional effects of monetary policy on labor market outcomes are not consistent for all types of workers. Namely, the co-authors show that highly skilled workers – defined in the working paper as workers with at least a college degree – benefit the most in terms of wages and hours worked. A 1 percentage point cut in the policy rate is associated with an increase of 1.14 percentage points in wages and 2.7 percentage points in hours worked for high-skilled workers, compared to the results for low-skilled workers.
Moreover, Jasova and her co-authors find that these skill premium effects are concentrated in smaller and younger firms. As highly skilled and well-paid workers tend to be already employed by large, high-wage companies, expansionary monetary policy is associated with a reallocation of skilled labor to small firms. The co-authors argue, consistent with the capital-skills complementarity mechanism, that expansionary monetary policy disproportionately allows financially constrained firms to increase both capital investment and the employment of skilled workers. These results are consistent with the typical macroeconomic explanation of monetary policy leading to faster economic growth, but this research provides new details that map this macroeconomic story to different firms and workers.
Admittedly, expansionary monetary policy is associated with economically and statistically significant wage effects in small and young firms only if they have already taken out bank loans. On the other hand, the effects are nil for the employees of companies which have not contracted any bank loan during the previous periods. The research therefore highlights the importance of the credit channel for the distributive effects of monetary policy on the labor market. In other words, while smaller and younger firms may benefit the most from increased access to credit in times of expansionary monetary policy, to the extent that it may help ease financial constraints, it does not matter only if the company has an existing bank loan relationship.
Other economists have also highlighted how expansionary monetary policies can reduce inequality. For instance, a document by University of Texas at Austin economist Olivier Coibion and his co-authors find that the Federal Reserve’s expansionary monetary policies reduce income and consumption inequality among American households, while price shocks Restrictive monetary policy increases income and consumption inequality in the United States. The contrasting effects are mainly due to differences in the composition of household incomes and balance sheets across the income distribution in the United States. Contrary to claims that expansionary policy in the form of low interest rates increased inequality through asset prices, this work shows the opposite.
In Facing Inequality: How Societies Can Choose Inclusive Growth, economists Jonathan D. Ostry, Prakash Loungani, and Andrew Berg also find that periods of monetary policy expansion are associated with reduced income inequality around the world, with labor’s share of income rising and labor shares rising. income reaching the top 10%, 5% and 1%, all down. They conclude that there is evidence that unexpected or exogenous monetary policy easing reduces income inequality.
Monetary policy can also have distributive effects on wealth, although these effects are less well understood. To research by Michele Lenza and Jiri Slacalek of the European Central Bank find that with expansionary monetary policy, wealthy households tend to benefit from rising stock prices, while middle-rich households benefit from rising oil prices immovable. There are household balance sheet effects, but many low-income households have too little wealth (positive or negative) to be affected by this channel.
Nonetheless, more research is needed to draw firm conclusions about the distributional effects of monetary policy, especially during episodes of inflation. We are in the middle of a historic restrictive monetary policyand research will be needed to understand how current policy affects inequality.
There are also other important questions to study in order to provide a complete picture of the relationship between monetary policy, inequality and growth. How do financial market responses to changes in monetary policy affect wealth inequality? How do the costs of inflation vary by household characteristics, such as age, income, or race? How do a household’s assets and debts affect its inflation experience? Equitable growth aims to support researchers answer these questions and more.