Inequality and Optimal Monetary Policy∗ Dong-Whan Ko†

In this paper, I investigate the effect of income inequality on optimal monetary policy design. To this end, I introduce heterogeneity by incorporating segmented labor markets with a Limited Asset Market Participation (LAMP) into the standard New Keynesian DSGE model used in Erceg et al. (2000). Because of the difference in real rigidity across sectors, an economic shock, especially a monetary policy shock, causes a variation in the wage premium. This variation in wage premium encourages firms to substitute workers across sectors, which induces stickier aggregate nominal wage and more volatile macroeconomic variables. At the same time, however, a change in wage premium leads to a greater change in the employment gap across sectors (given a plausible value of elasticity of substitution), and thus income inequality is negatively related to the wage premium. In addition, income inequality poses a trade-off with traditional policy objectives such as the output gap even under flexible wages. Therefore, it is desirable to include inequality as a separate goal for a Central Bank. Welfare analysis of various scenarios shows that when a Central Bank ignores inequality, focusing only on aggregate variables, there are significant welfare losses