Conventional wisdom suggests that the impact of monetary policy on the distribution of income between workers and owners of capital is to reduce labour’s share when interest rates rise. In fact, the impact is the opposite, according to research to be presented at the Royal Economic Society's annual conference at the University of Warwick in April 2019.
Analysing evidence from five developed economies (Australia, Canada, the European Union, the UK and the United States), Cristiano Cantore (Bank of England, Centre for Macroeconomics and University of Surrey), Filippo Ferroni (Federal Reserve Bank of Chicago) and Miguel León-Ledesma (University of Kent and CEPR) illustrate that the share of output allocated to wages (the ‘labour share’) actually increases following a positive shock to the interest rate.
This means that the slice of the pie enjoyed by those whose earnings are mostly made up of wages increases at the expense of profits and capital income.
Strikingly, this redistribution channel that shows up in the data runs precisely in the opposite direction to the predictions of the standard New Keynesian analysis that is commonly used to study the effects of monetary policy.
Despite its importance, there is no systematic empirical evidence on the effect of monetary policy shocks on the labour share. In their study, Cantore et al (2018) provide new empirical evidence on the effect of monetary policy surprises on the labour share for the five developed countries from the mid-1980s until the Great Recession.
As interest rates can vary for many reasons, identifying an exogenous variation in the rates that is attributable to monetary policy is a complex matter. To this end, the authors explore various approaches proposed in previous macroeconomic research, and find consistently that the labour share increases in all the countries under study following a monetary policy shock.
During the past few decades, New Keynesian models have been the principal theoretical means for economists to explore the transmission mechanism of monetary policy. In these models, monetary policy affects inflation and real economic activity through the effect of interest rate changes on the mark-ups that firms charge over their marginal costs of production. Changes in mark-ups redistribute income between labour and profits. A higher mark-up would imply a lower labour share.
The essence of that mechanism is as follows: a rise in interest rates will tend to reduce demand and when prices cannot adjust immediately, this implies that prices are too high relative to the new level of demand. They are not at their optimal lower level to equate demand and supply. Since prices are above optimal, firms are charging a higher mark-up. As mark-ups rise, the labour share of income falls and the profit share (mark-ups) increases.
But strikingly, the sign of this effect goes in the opposite direction in the empirical evidence in the new study. The authors’ results indicate that a tightening of monetary policy increases the labour share – precisely the opposite of what the standard models would say.
The researchers then analyse whether various available extensions of New Keynesian models can match their empirical evidence, studying different families of models commonly used in macroeconomics for the analysis of monetary policy.
The key result is that these models generate the ‘wrong sign’ for the effect on labour share when compared with the empirical results. Several of the models do a reasonable job at matching the responses of standard macroeconomic variables to an identified monetary policy shock, but they are unable to reproduce the response of the labour share.
These results emphasise that macroeconomics needs to develop models that are able to replicate the cyclical behaviour of the labour share and its components. This is crucial in order to analyse the distributional effects of monetary shocks.
‘The Missing Link: Monetary Policy and The Labour Share’ by Cristiano Cantore (Bank of England, Centre for Macroeconomics and University of Surrey), Filippo Ferroni (Federal Reserve Bank of Chicago) and Miguel León-Ledesma (University of Kent and CEPR).