Most recent models prove that central banks can combat inflation while focusing on inequality

“2021 Annual Economic Report,” Bank for International Settlements, June 2021, https://www.bis.org/publ/arpdf/ar2021e.pdf

[[Begin Box II.B]]

Heterogeneity and distribution in macroeconomic models

The growing focus on inequality in the economic debate has gone hand in hand with a change of perspective in macroeconomic modelling. Recent research has moved away from macroeconomic models based on a single representative agent and has focused instead on frameworks that incorporate heterogeneity in skills or wealth among households. This has allowed researchers to explore how inequality shapes macroeconomic outcomes and how macroeconomic shocks and stabilisation policies affect it. In these models – known as heterogeneous agent New Keynesian (HANK) models – several traditional policy prescriptions change when household heterogeneity is taken into account.

In traditional representative agent New Keynesian (RANK) models, monetary policy operates almost exclusively through a direct “real interest rate channel”: changes in the policy rate affect the real interest rate and induce households to reallocate consumption and saving over time. For instance, lower rates encourage them to bring consumption forward, reducing saving rates today. Yet empirical evidence shows that the response of consumption to monetary policy is mainly due to the indirect impact arising from an increase in employment and wages.

In RANK models, the impact of these indirect effects on consumption is small because the representative agent is generally assumed to be able to smooth consumption over time and is therefore not highly responsive to temporary income changes.

In HANK models, the direct impact from the “real interest rate channel” is small because a sizeable share of agents – especially those at the very bottom of the distribution – have negligible wealth. These agents’ consumption reacts little to changes in interest rates but is instead highly sensitive to changes in labour income (“labour income channel”). In addition, agents at the top of the wealth distribution hold equity and hence benefit from asset price increases (“equity price channel”) in response to an expansionary monetary policy.

Overall, the transmission of a monetary policy expansion can be weaker in HANK models than in RANK models. This depends on the distribution of income and wealth, and on other household characteristics that affect the relative strength of the different channels. The impact will be smaller in HANK if the “labour income channel” and the “equity price channel” are not strong enough to offset the weaker “real interest rate channel”. In HANK models distributional factors also shape the optimal policy design: the main objective remains low and stable inflation, but the relative weight on unemployment in central banks’ strategy is higher. Considering inequality, a larger weight on unemployment stabilisation benefits the majority of households, as a more aggressive reaction to unemployment lowers earnings risk and precautionary savings by the employed and unemployed households at low and medium wealth deciles.

[[End Box II.B]]