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January 28, 2020—The Bank of Canada should weigh how income inequality affects monetary policy effectiveness as it pursues its 2 percent inflation target, says a new report from the C.D. Howe Institute.

In “Monetary Policy, Income Inequality, and Inflation—What’s the Link?” authors Jeremy Kronick and Francisco Villarreal investigate the link between monetary policy, income inequality and inflation in Canada, and explore why and how inflation plays a role.

Income inequality largely increased from the time the Bank of Canada began targeting inflation, through the late 1990s to the early 2000s, and flattened or decreased after the 2008 financial crisis.

Against this backdrop, the authors show that expansionary monetary policy shocks, triggered by a lower than expected bank rate, lead to increasing income inequality, whereas contractionary monetary policy shocks help reduce income inequality. The authors then show that these effects are asymmetric, with expansionary shocks having a greater impact on income inequality than contractionary shocks.

While the effect of a contractionary monetary policy shock reduces inflation, an expansionary shock has a mostly insignificant effect on inflation.

The reason: expansionary monetary policy shocks result in a higher share of national income shifting to higher income households, who consume less as a percentage of their income, dampening the increase in aggregate demand, and, therefore, inflation. “With expansionary monetary policy, more resources end up in the hands of capital owners, who tend to be better off than lower-income wage earners, and consume less out of their income,” says Kronick. “This has a dampening effect on inflation, and may help explain part of the tepid response to expansionary monetary policy in the post-crisis period.”

Although the central bank is not responsible for inequality directly, the authors’ results make clear that not accounting for the differing responses of income groups may lead to false interpretations by central bankers of the likely impact of a monetary policy shock on inflation.

“Our results lead to one particularly important conclusion for monetary policy,” write Kronick and Villarreal. “Namely, that the Bank of Canada needs to account for the impact of income inequality when modeling how inflation will respond to a change in the overnight rate.”

For more information contact: Jeremy Kronick, Associate Director, Research, C.D. Howe Institute; Francisco Villarreal, Economic Affairs Officer, United Nations’ Economic Commission for Latin America and the Caribbean; or Nancy Schlömer, Communications Officer, C.D. Howe Institute, phone 416-865-1904 ext. 0247, email: nschlomer@cdhowe.org.

The C.D. Howe Institute is an independent not-for-profit research institute whose mission is to raise living standards by fostering economically sound public policies. Widely considered to be Canada's most influential think tank, the Institute is a trusted source of essential policy intelligence, distinguished by research that is nonpartisan, evidence-based and subject to definitive expert review.