Inequality shapes US policy spillovers, diverts in AEs/EMEs
A new ECB working paper finds income inequality significantly alters how US monetary policy spillovers affect foreign GDP. While higher inequality amplifies negative impacts in advanced economies, it mitigates them in emerging markets due to differences in financial market access.
Divergent paths for advanced and emerging economies
The study provides novel evidence on how income inequality shapes the heterogeneity of US monetary policy spillovers to GDP across foreign economies.
Using data from 87 countries over 1966-2020, researchers show that foreign GDP contracts up to one and a half times more when inequality is above average following a US monetary tightening.
However, this relationship is not uniform: higher inequality consistently amplifies negative spillovers in advanced economies, strengthening the contractionary effects.
Conversely, in emerging markets, higher inequality appears to mitigate these negative spillovers, leading to smaller declines in economic activity.
This key finding highlights a complex, non-linear interaction between domestic income distribution and international monetary policy transmission.
Financial market access drives divergence
The paper rationalizes these contrasting patterns using a three-country open economy Two-Agent New Keynesian (TANK) model.
This model suggests the divergence is driven by differences in household participation in international financial markets.
In advanced economies, widespread access allows unconstrained households to reallocate portfolios towards higher-return US assets after a tightening, amplifying capital outflows and negative domestic impacts.
In emerging markets, however, limited access restricts this portfolio rebalancing, weakening the capital outflow channel and dampening US monetary policy transmission.
Beyond simple spillovers
This research fundamentally reframes the understanding of global monetary policy transmission, moving beyond a one-size-fits-all approach.
It underscores that domestic structural factors, particularly financial market access, are crucial in mediating international shocks.
Policymakers must now consider internal inequalities as a key determinant of external vulnerability.