We develop a dynamic stochastic general equilibrium model to examine how monetary policy shocks affect income inequality and the equity premium. The model features Ricardian and non-Ricardian households and shows that a monetary policy tightening causes an endogenous redistribution of income from non-Ricardians to Ricardians. Ricardians’ consumption comoves more strongly with asset returns, giving rise to high equity premia. We extend our model with several frictions and estimate it with generalized method of moments using US macroeconomic and financial data from 1960 to 2007. We find that the estimated model jointly matches the bond and equity premia. We complement our theoretical model with vector autoregression estimations and show that a tightening of US monetary policy increases equity premia.

Introduction

Following the recent financial crisis, there is a renewed interest in exploring the interactions between monetary policy and income inequality (Coibion et al., 2017; Davtyan, 2017). Traditionally, it has been assumed that the distributional effects of the monetary policy rate net out over the business cycle, and therefore, the interactions between monetary policy and inequality have rarely been examined. However, some recent papers show that monetary policy affects income inequality (Coibion et al., 2017) through various channels, such as financial segmentation. It has also been shown that income inequality can become a monetary policy transmission channel itself through earnings heterogeneity (Auclert, 2019). This is because low-income households typically have a higher marginal propensity to consume, and therefore, these households may benefit from monetary expansion more than rich households do. Although the literature examining the effects of monetary policy on income inequality is growing, the implications of income redistribution from a macro-finance perspective have not received sufficient attention in the literature so far. We try to bridge this gap in this paper. Specifically, our paper measures the effect of income redistribution on matching financial and macroeconomic moments jointly in a model with limited asset market participation (LAMP). Importantly, in our paper, income redistribution occurs endogenously, i.e., it is caused by monetary policy shocks. This approach extends the previous literature, which assumes exogenous redistribution shocks (see, e.g., Lansing (2015)). The current literature examining the effects of monetary policy on equity premia has focused on other issues, for example, on the role of market volatility (Mallick et al., 2017). Our first contribution is to show that monetary policy shocks are the source of the high equity risk premia in a simple model with LAMP. Our model is populated by Ricardian and non-Ricardian households. The former have access to bonds to smooth their consumption (‘optimizers’), while the latter do not. This unequal access implies that a limited share of the population participates in financial markets. NonRicardians receive only labor income, while Ricardians hold equity shares in firms.