DP12734 Monetary Policy and Inequality under Labor Market Frictions and Capital-Skill Complementarity

Author(s): Juan J. Dolado, Gergo Motyovszki, Evi Pappa
Publication Date: February 2018
Keyword(s): capital-skill complementarity, inequality, monetary policy, Search and Matching
JEL(s): E24, E25, E52, J64
Programme Areas: Labour Economics, Monetary Economics and Fluctuations
Link to this Page: www.cepr.org/active/publications/discussion_papers/dp.php?dpno=12734

Contrary to previous beliefs, recent empirical work has found that the effects of monetary policy on inequality are far from modest. In order to improve our understanding of the channels through which monetary policy has distributional consequences, we build a New Keynesian model with incomplete asset markets, asymmetric search and matching (SAM) frictions across skilled and unskilled workers and, foremost, capital-skill complementarity (CSC) in the production function. Our main finding is that an unexpected monetary easing increases labor income inequality between high and low-skilled workers, and that the interaction between CSC and SAM asymmetry is crucial in delivering this result. This is so since the increase in labor demand driven by a monetary expansion leads to larger wage increases for high-skilled workers than for low-skilled workers since the former have smaller matching frictions (SAM-asymmetry channel). Moreover, the increase in capital demand amplifies this wage divergence due to skilled workers being more complementary to capital than substitutable unskilled workers are (CSC channel). Strict inflation targeting is often the most successful rule in stabilizing measures of earnings inequality even in the presence of shocks which introduce a trade-off between stabilizing inflation and aggregate demand.