A recent trend in research emphasises the implications of monetary policy not only for aggregate outcomes like inflation or the unemployment rate, but also for inequality. The trend has motivated, for example, several columns on Vox discussing the empirical impact of monetary shocks on the distribution of income and wealth (e.g. Ampudia et al. 2018, Holm-Hadulla et al. 2022, Mäki-Fränti et al. 2022).
At the same time, central banks face significant pressures to incorporate equality and equity into their official objectives. In the US, the Federal Reserve Racial and Economic Equity Act was introduced in Congress in April 2021, which proposed, as a main objective, amending the Federal Reserve Act in order to make “reducing inequality part of the Fed’s mission”.
Similar debates are occurring in the rest of the world.
Remarkably, economists remain reluctant to include distributional concerns as a factor in monetary policy. For instance, Ilzetzki (2021) reports that only 14% of the participants in a Centre for Macroeconomics (CfM) survey “believe that inequality should play a substantive role in monetary policy decisions”. One possible reason is that “our state of knowledge on the topic is still in its infancy”. Such ignorance is indeed a main motivation for the research agenda mentioned above.
However, even if one could evaluate accurately the effects of monetary policy on inequality, the question of whether equality should be added to the list of objectives of a central bank would remain unsettled. This is largely because the answer hinges on the meaning of “should”. In the presence of heterogeneity, monetary policy decisions result in winners and losers, so evaluating the net benefits to society of alternative policies requires taking a stance on how to aggregate the conflicting impacts or, in the jargon of economists, requires agreeing on the relevant social welfare function. But reasonable people can disagree on what is the ‘right’ or ’just’ function, and especially on the weight that inequality might have in it. The reluctance of the economists quoted in the CfM survey may reflect their recognition that, on identifying the appropriate social welfare function, economics hardly has a comparative advantage relative to other disciplines, including ethics and political philosophy.
Arguably, however, economists do have a lot more to contribute to the debate, provided we approach it from a different perspective. Our focus should not be on defining the social objective function, but instead on the related, complementary question of what the central bank's mandate should be for a given social objective function. Here the perspective from economics is useful, natural, compelling, and surprising.
I pursue this alternative approach in a recent paper (Chang 2022). The argument is developed in the context of a textbook model, due to Persson and Tabellini (1992), of monetary policy with the typical time inconsistency problem of Kydland and Prescott (1977) and Calvo (1978).
In the Persson-Tabellini model, all individuals are assumed to be identical to each other and to work, consume, and save in the form of fiat money. The central bank sets monetary policy to maximise the utility of the representative agent, which is the obvious measure of social welfare. As the economy lasts many periods, there is a socially optimal outcome involving a suitable multi-period plan for monetary policy. The optimal outcome is implemented if the central bank announces that policy plan at the beginning of time and sticks to it over time.
As time passes, however, the central bank will be tempted to raise inflation over its originally announced level. This occurs because the government collects revenue via money creation, as well as other taxes; in contrast to those other taxes, inflation tax is not distortionary ex post, since it is imposed on money holdings determined in previous periods. Hence, unless the central bank can commit to honour its initial policy promises, it will break those promises. But then, anticipating the central bank’s incentives, the public will expect higher inflation than is socially optimal, and respond by reducing their money demands ex ante. In turn, reduced money demand will force the central bank to increase the inflation tax over and above its socially optimal level. In the absence of policy commitment, therefore, the economy suffers from the inflationary bias problem of Kydland and Prescott (1977) and Calvo (1978).
Consider now what happens if, departing from the original Persson-Tabellini model, the assumption of identical agents is dropped. A first implication is that, as noted above, there is no obvious social welfare function; but as also suggested above, our analysis can proceed taking as given some well-defined social welfare function, which is an aggregate of individual utilities.
The simplest case is one in which social welfare is given by the average of individual utilities. As I show in Chang (2022), social preferences then depend only on mean consumption and, as a consequence, the analysis of policy turns out to be almost the same as in the case of no heterogeneity, under the important proviso that the central bank sets policy to maximise the social welfare function (that is, average utility). In particular, in the absence of commitment, monetary policy suffers from inflationary bias.
Not everything remains the same, however. With heterogeneity, inflation has a redistributive impact. In each period, the inflation tax collects more revenue from agents that arrive to that period with higher money balances. Intuitively, an inflation surprise takes more from wealthier agents than for poorer agents.
This crucial fact implies that a superior outcome is available if the central bank is given a mandate that differs from the social welfare function. Considering central bank mandates that assign different weights to different individual utilities, I identify a choice of weights that, under discretion, implements the socially optimal outcome. And, strikingly, the optimal weights turn out to be increasing in individual wealth. In other words, it turns out to be optimal for society to give the central bank a mandate that pays attention to inequality, but the mandate should give relatively more weight to wealthier agents, not to poorer ones.
The intuition is simple. Given the inflation bias problem, a key role of the mandate is to penalise the central bank for creating surprise inflation; one way to do that is to design a mandate sufficiently averse to redistribution. Since surprise inflation redistributes resources from agents with higher nominal wealth to those with lower nominal wealth, assigning higher relative weight to the former group in the mandate turns out to be an effective way to provide proper incentives.
This finding can be regarded as a 21st century version of the celebrated ‘conservative central banker’ argument of Rogoff (1985). Rogoff showed that, in the presence of time inconsistency, society would benefit from appointing a central banker with a stronger distaste for inflation relative to unemployment than itself. Here we find that, in the presence of heterogeneity, it is beneficial for society to appoint a central banker less egalitarian than society itself.
The analysis readily extends to more general settings. In particular, if the social welfare function values equality (which average utility does not), the socially optimal outcome is attained by giving the central bank a mandate less egalitarian than the social welfare function.
Notably, in this case, the mandate may turn out to be egalitarian in the sense of imposing a penalty for inequality; but it is necessary that the penalty in the mandate be smaller than in the social welfare function. And it cannot be overemphasised that the optimal mandate delivers an outcome that is best from the egalitarian social welfare viewpoint, even if the mandate is not itself egalitarian.
My analysis thus implies that adding distribution to the list of central bank objectives can be justified by its role in offsetting policy distortions. More generally, the approach shifts attention away from a debate about the ‘right’ social objectives and towards how a central bank's mandate can help accomplishing those objectives. This line of argument has been effective to justify institutional aspects of successful central banks, including independence and inflation targeting. We have seen that it can also rationalise the inclusion of distributional concerns in the central bank mandate, and that the change of perspective delivers unexpected insights.
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Calvo, G (1978), "On the Time Consistency of Optimal Policy in a Monetary Economy", Econometrica 46: 647-661.
Carstens, A (2021), "Central Banks and Inequality", Remarks to Markus' Academy, Bendheim Center for Finance, Princeton University, 6 May.
Chang, R (2022), “Should Central Banks Have an Inequality Objective?”, NBER Working Paper 30667.
Holm-Hadulla, F, T Renault, and S Hauptmeier (2022), “Risk sharing and monetary policy transmission”, VoxEU.org, 5 December.
Ilzetzki, E (2021), “Monetary policy and inequality”, VoxEU.org, 18 August.
Kaplan, G, B Moll and G Violante (2018), "Monetary Policy According to HANK ", American Economic Review 108: 697-743.
Kydland, F and E Prescott (1977), "Rules Rather Than Discretion: The Inconsistency of Optimal Plans", Journal of Political Economy 85: 473-490
Mäki-Fränti, P, A Silvo, A Gulan, and J Kilponen (2022), “The impact of monetary policy on income and wealth inequality”, VoxEU.org, 11 February.
Persson, T and G Tabellini (1990), Macroeconomic Policy, Credibility and Politics, Harwood Academic Publishers.
Rogoff, K (1985), "The Optimal Degree of Commitment to an Intermediate Monetary Target", Quarterly Journal of Economics 100: 1169-1190
Warren, E (2021), "Federal Reserve Racial and Economic Equity Act One Pager" (at https://www.warren.senate.gov).