Finance and Economics Discussion Series (FEDS)

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July 2018

Income Inequality, Financial Crises, and Monetary Policy

Isabel Cairo and Jae W. Sim

Abstract:

We construct a general equilibrium model in which income inequality results in insufficient aggregate demand, deflation pressure, and excessive credit growth by allocating income to agents featuring low marginal propensity to consume, and if excessive, can lead to an endogenous financial crisis. This economy generates distributions for equilibrium prices and quantities that are highly skewed to the downside due to financial crises and the liquidity trap. Consequently, symmetric monetary policy rules designed to minimize fluctuations around fixed means become inefficient. A simultaneous reduction in inflation volatility and mean unemployment rate is feasible when an asymmetric policy rule is adopted.
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Keywords: Monetary policy, credit, financial crises, income inequality

DOI: https://doi.org/10.17016/FEDS.2018.048

PDF: Full Paper

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Last Update: January 09, 2020