Vincent Sterk (ULC), 02.11.2022

This paper studies the effects of monetary policy during times when sectoral supply shocks raise the cost of living, in particular for low-income households. We present a multi-sector Heterogeneous-Agents New-Keynesian model with a generalized, non-homothetic preferences, giving rise to heterogeneous consumption baskets and demand elasticities across the income and wealth distribution. In this setting, household inequality directly affects the New Keynesian Phillips Curve, in which an endogenous “markup wedge” emerges. The presence of this wedge creates a trade-off in managing the aggregate output gap versus inflation, which can be particularly strong following sector-specific shocks. In addition, such shocks can create strong distributional effects, which monetary policy may help to address. We evaluate the policy trade-offs in a quantitative analysis, applied to the United Kingdom.

Coauthors: Alan Olivi and Dajana Xhani