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