The effect of monetary policy on inflation heterogeneity along the income distribution

Summary

Focus

Monetary policy has distributional effects – because a change in interest rates affects agents differently depending on their interest rate exposure, because income and wealth are affected differently, and possibly also because inflation responds differently across agents. While there is a large literature on the wealth and income effects of monetary policy, the effects on inflation differentials have barely been studied.

There are two main channels through which inflation might show a differential response to monetary policy along the income distribution. First, because households consume different consumption bundles, the prices of which respond differently to monetary policy. Second, households pay different prices for the same items, and those prices respond differently to monetary policy.

Contribution

This paper studies the response of inflation to the ECB's monetary policy across the income distribution in the six largest euro area countries (ie Germany, France, Italy, Spain, the Netherlands and Belgium). Importantly, it considers both sources of variation identified in the literature, those due to differences in the consumption basket along the income distribution as well as those arising from differences in purchasing behaviour.

Findings

The paper shows that monetary policy does indeed affect inflation differently across the income distribution. It reveals that these differences stem from two different channels, which work in opposite directions. On the one hand, different consumption baskets imply that the inflation of high-income households responds less to monetary policy. On the other hand, differences in shopping behaviour are substantial and imply that the inflation experienced by high-income households responds more to monetary policy, making the overall effect ambiguous.

Abstract

This paper studies the effect of monetary policy on inflation along the income distribution in several euro area countries. It shows that monetary policy has differential effects and identifies two channels which point in opposite directions. On the one hand, different consumption shares imply that inflation by high-income households responds less to monetary policy. On the other hand, the paper provides novel evidence that there are substantial differences in shopping behaviour and its reaction to monetary policy, which imply that inflation by high-income households responds more to monetary policy.

JEL classification: E31, E52, D30

Keywords: inflation, distributional effects, monetary policy, shopping behaviour, substitution