DP19872 High Non-Tradable Consumption, Inequality, and Weak Monetary Policy
How does the composition of consumption expenditure influence the transmission of monetary policy across countries in a monetary union? We document three empirical findings using micro and macro data from euro-area countries. First, countries with a higher expenditure share on non-tradable consumption exhibit weaker output responses to monetary policy shocks. Second, countries with higher income inequality display larger aggregate expenditure shares on non-tradable consumption. Third, within countries, households with higher incomes allocate a larger share of their expenditure to non-tradables. We rationalize these findings through a model of a monetary union with three key features: heterogeneous agents, non-homothetic preferences, and incomplete markets. Inequality is pro-cyclical when richer households earn income from the luxury non-tradable sector. Pro-cyclical inequality weakens monetary policy transmission, rationalizing its mild effects on output in unequal countries with high non-tradable expenditure shares. The model is also consistent with the empirical evidence on trade imbalances and sectoral output responses within the monetary union in response to monetary policy shocks.
