The only way to offset the overall adverse impact on incomes of the poor, and thus increase in inequality, is through government transfers
The relationship between monetary policy shocks, especially those driven by unconventional monetary policies, and income inequality, is unclear. Some studies have shown that unconventional expansionary monetary policies, such as the US’ quantitative easing, had a positive impact on reducing income inequality. A recent paper by Masayuki Inui, Nao Sudo and Tomoaki Yamada (https://goo.gl/Bmrc2f) analyses the distributional impact of monetary policies on inequality in Japan and finds results to the contrary. Moreover, the authors find that the key to mitigating the negative influence of such policies on income inequality is through labour market flexibility. With differences in the nature of economic activity across firms, low labour market flexibility would result in cross-firm heterogeneity of earnings per employee, thereby increasing income inequality across households.
There are five potential channels through which the distributional effects of unconventional expansionary monetary policy shocks are experienced. However, the impact of these channels on income inequality is not uniform.
The first is the earnings heterogeneity channel. Depending on factors such as the degree of labour unionization, stickiness of nominal wage and labour market flexibility, it refers to the differential response of earnings to a monetary policy shock across workers. The second is the job creation channel, which refers to the effect of a monetary policy shock on inequality through creation or destruction of jobs in the aftermath of the shock. The income composition channel works through the differential impact on inequality because of the difference in the income composition across households, such as labour and capital income and government transfers. The portfolio channels arise when households vary by the size and composition of asset portfolios they hold.
Thus, expansionary unconventional monetary policies with their inflationary effects are likely to affect the asset portfolios of the poor negatively, since the real value of cash reduces following such a shock. On the other hand, the asset portfolios of the rich, comprising equity, are likely to be positively affected, thereby accentuating income inequality. A novel channel for transmission of monetary policy is the savings redistribution channel. It arises from the inflationary effect of expansionary monetary policies on debt. Thus, in a scenario of rich lenders and poor borrowers, expansionary monetary policies would lead to wealth transfers from the rich to the poor and hence reduce income inequality.
Labour markets in Japan were traditionally rigid, characterized by “life-time employment or one job for a life". Hence, expansionary monetary policies, working through the five channels, had an adverse impact on income inequality. However, Japan has witnessed the emergence and expansion of temporary work since the 1990s. The resultant increasing labour mobility, the authors contend, was responsible for the decoupling of variation in goods production across firms from variation in earnings across workers. At the same time, such labour market flexibility and the use of temporary workers is associated with intra-firm wage differences among different profiles of workers, and thus has the potential to accentuate income inequality across households.
India’s demonetisation in November 2016 was a different type of unconventional monetary policy, aimed at reducing money supply to achieve an unconventional “monetary" objective, viz. reducing black money and corruption, as also to counter terrorism through reducing counterfeit notes. How would demonetisation have affected income inequality through these five channels?
The unorganized sector in India—accounting for 82.4% share in the total employment and 45% share in the gross value added—is highly cash intensive, with little or no labour unionization and lower labour market flexibility. The earnings heterogeneity channel would increase income differentials among organized and unorganized sector workers and accentuate income inequality. Demonetisation had a significant impact on job destruction, especially across various micro, medium and small enterprises, thereby leading to an adverse impact via the job creation channel. It would be fair to assume that the portfolio channels would have had a neutral impact on inequality.
While asset portfolios of the poor had a high proportion of cash, more than 97% of the scrapped cash came back to the banking system by 30 December 2016, thereby not affecting the portfolios of the poor substantially. The savings redistribution channel impact can be assessed through analysing the composition and trends in household debt in India (https://goo.gl/btsBSk). With the rural poor being the debtors and non-institutional agricultural moneylenders, landlords, traders, etc., being the creditors, demonetisation and the resultant decline in inflation is likely to have affected the borrowers negatively and transferred wealth from the poor borrowers to the rich lenders.
With three (of the four) channels likely to accentuate the adverse impact of demonetisation on income inequality in India, as also the lack of labour market flexibility in India, it is only government transfers acting through the income composition channel which carry the potential to mitigate the effect of demonetisation on incomes of the poor and hence income inequality.
Recent figures paint a dismal picture of overall growth and declining private investment, as also such growth being propped by the 35.6% contribution of the government sector. However, the per capita gross national disposable income of Rs118,395 compared to the per capita gross domestic product of Rs116,888, indicates a silver lining. The difference between these two figures is a measure of the extent of government transfers. Without such public expenditure, and government transfers, the impact on income inequality is likely to have been far greater. Household income and expenditure data, as and when published by the National Council of Applied Economic Research, is likely to reveal interesting quantitative facets of the distributional impact of demonetisation. Meanwhile, the government should be forewarned of this important link. In the short run, the only way to mitigate the counter-cyclical impact on inequality may be through expansionary fiscal policies, even if at the cost of a larger fiscal deficit.
Tulsi Jayakumar is professor of economics at the SP Jain Institute of Management & Research, Mumbai.