Central bankers usually steer clear of discussions about inequality. They view monetary policy as a tool for stabilizing the economy. For many central banks, like the ECB or the Bank of England, this means price stability. For others, like the Federal Reserve, it means a combination of high employment and low inflation. Regardless of the goals, issues involving the distribution of income are generally left to the fiscal authorities.
For the most part, this division of labor is sensible. However, their mandates require central banks to make policy tradeoffs that are influenced by the prevailing income distribution. Specifically, the way in which monetary policy is conducted should depend on the access individuals have to the financial system, including both savings and credit. And we believe that it does.
To understand why monetary policy depends on the degree of “financial inclusion,” we need to explain two aspects of policy. First, policymakers face a tradeoff, not between the level of growth (or employment) and inflation, but between their variability. Second, faced with temporary fluctuations in their income, people with access to credit and savings through the financial system have the ability to smooth their consumption in a way that others do not.
Let’s start with the policy tradeoff. When unexpected events come along, they can move inflation and output temporarily away from their respective long-run paths. That is, shocks shift inflation away from the central bank’s target and current output away from its potential level (technically, away from the “normal” level of output consistent with flexible prices and wages).
Now, such disturbances fall into two broad categories: those that move output and inflation in the same direction (call them demand shocks) and those that move them in opposite directions (supply shocks). An example of a demand shock is a change in optimism about the future. This influences consumption and investment, changing (aggregate) demand and moving inflation and output up or down together. The classic example of a supply disturbance is an unexpected change in the supply of oil. A decline leads to both an increase in inflation and a rise in the cost of production that depresses the level of output.
Monetary policy acts like an aggregate demand shock. It moves inflation and output in the same direction. This has two immediate and very important implications. First, when a shock moves both inflation and output in the same direction – as a change in consumer and business sentiment would – then, under ideal circumstances, monetary policy can offset it. By contrast, when inflation and output move in the opposite direction, policymakers face a tradeoff. They must decide whether they are more concerned about keeping inflation close to its target (thus minimizing the “inflation gap”) or about keeping output close to potential (thus minimizing the “output gap”). The more aggressive they are at responding to one deviation, the bigger the gap in the other, at least temporarily.
Sometimes called a “Taylor curve", this tradeoff between the variance of inflation and the variance of the output gap looks like the set of feasible policy choices depicted in the figure below. While any point up and to the right of the frontier is feasible, a central banker will view the Taylor curve as a an efficient policy frontier -- a menu of options along which they can choose a point that corresponds to their relative preferences for inflation stability and output stability. (The original technical derivation of this tradeoff is here.)
Taylor Curve: Tradeoff of inflation and output gap variability
Before continuing, we should emphasize that all of this is consistent with inflation targeting as the framework for central bank policy. That is, even a central bank with a publicly announced inflation objective (including the Bank of England, Bank of Japan, European Central Bank, and Federal Reserve) will have to choose a point on this volatility tradeoff.
Our argument is that financial inclusion should and does affect a central bank’s preference for where they end up. The reason is that monetary policymakers appropriately take account of the ability of residents to smooth their consumption in the face of unanticipated income shocks.
The idea that people prefer smoother to more variable consumption is at the heart of much of economic analysis. It goes by names like the “permanent-income hypothesis” or the “life-cycle hypothesis” and is based on the notion that individuals try to keep their consumption relatively constant throughout their lives. Indeed, most of us try not to suddenly alter our major expenditures (say, for housing or transportation) or our daily outlays (including heat, electricity and food). This means that we seek to keep our monthly and annual expenditures relatively constant come what may.
What do we do in the face of misfortune, like the temporary loss of a job? Where feasible, people typically dip into their savings or borrow to maintain their standard of living. Only if unemployment is expected to persist, or a new job is likely to have lower or higher pay than the old one, will a person adjust spending for the long run.
The process we have just described – using savings or borrowing to smooth consumption when income fluctuates – requires access to the financial system. Without it, a person might seek aid from family and friends, but the ability to sustain spending when income temporarily declines will be limited. In other words, people who have access to the financial system are in a better position to weather transitory income shocks than people who aren’t. In the parlance of economics, the “unbanked” population is liquidity constrained.
This brings us back to central bankers and their choice of the point on the inflation-output volatility frontier. The conclusion is that the lower the level of financial inclusion in a country, the more policymakers should try to reduce output volatility. That is, when individuals are less able to use the financial system to smooth consumption, the greater the relative weight that policymakers should place on stabilizing the output gap relative to stabilizing inflation.
According to a recent paper by Mehrotra and Yetman, this is indeed what happens. Using volatility measures kindly supplied by the paper’s authors, we have drawn the following chart that compares the ratio of the standard deviations of the gaps on the vertical axis against the World Bank’s financial inclusion measure on the horizontal axis. (See our previous post for a more detailed discussion of the World Bank’s Findex.)
Financial Inclusion and the Output-Inflation Volatility Tradeoff
Source: Graph 7 in Aaron Mehrotra and James Yetman, “Financial inclusion and optimal monetary policy,” BIS Working Paper No. 476, December 2014. Data are for 139 countries. The Findex data are from 2011, and the ratio of the standard deviations is computed using information from 2000 to 2012.
While the relationship is noisy, it is clearly positive: the higher the level of financial inclusion, the greater the ratio of output gap volatility to inflation volatility. This means that monetary policymakers typically do take account of the financial structure of their economies in carrying out their jobs. And the impact is fairly sizable. To see this, compare the U.S. inclusion rate (0.88), with that of the Philippines (0.27). We would expect the Federal Reserve to choose a point on the output-inflation volatility frontier that is much higher than that chosen by the Bangko Sentral ng Pilipinas. And, they do. In fact, the ratio of the standard deviation of the output gap to the standard deviation of inflation in the United States is twice what it is in the Philippines – consistent with the regression-fitted line in the chart.
So, in the end, central bankers do care about distributional issues. They have to. Social welfare depends on it. But they can choose only one point on the Taylor curve, and that probably means focusing on the needs of their median resident. Unfortunately, the more heterogeneous the level of financial access within a country, the more painful the policy tradeoff.
Over time, as financial inclusion improves and households become more able to smooth their spending, we would expect to see inflation become more stable and output more volatile. Stay tuned!