Monetary Policy and the Well-Being of the Poor

Poverty is arguably the most pressing economic problem of our time. And because rising inequality, for a given level of income, leads to greater poverty, the distribution of income is also a central concern. At the same time, monetary policy is one of the modern age's most potent tools for managing the economy. Given the importance of poverty' and the influence of monetary policy, it is natural to ask if monetary policy can be used as a tool to help the poor.

It is this possibility that we pursue in this paper. We examine the influence of monetary policy on poverty and inequality both over the business cycle in the United States and over the longer run in a large sample of countries. Our analysis suggests that there are indeed important links between monetary policy and the well-being of the poor in both the short run and the long run, but that the short-run and long-run relationships go in opposite directions. Expansionary monetary policy aimed at rapid output growth is associated with improved conditions for the poor in the short run, but prudent monetary policy aimed at low inflation and steady output growth is associated with enhanced well-being of the poor in the long run.

The existing literature on monetary policy and the poor focuses almost exclusively on the short run. Monetary policy cart affect output, unemployment, and inflation in the short run. As a result, if poverty and inequality respond to these variables, monetary policy can affect the well-being of the poor. Furthermore, because unanticipated inflation can redistribute wealth from creditors to debtors, monetary policy can also affect distribution through this channel.

In the first section of the paper, we provide some up-to-date estimates, of the cyclical behavior of poverty and inequality. We confirm the common finding that poverty falls when unemployment falls. In contrast to earlier authors, however, we find no evidence of important effects of cyclical movements in unemployment on the distribution of income. We find some evidence that unanticipated inflation narrows the income distribution, though we can detect no noticeable impact on poverty. Finally, using the Federal Reserve's Survey of Consumer Finances, we find that the potential redistributive effects of unanticipated inflation on the poor through capital gains and losses are very small.

Because of the short-run cyclicality of poverty, some authors have concluded that compassionate monetary policy is loose or expansionary policy. We, however, argue that this view misses the crucial fact that the cyclical effects of monetary policy on unemployment are inherently temporary. Monetary policy can generate a temporary boom, and hence a temporary reduction in poverty. But, as unemployment returns to the natural rate, poverty rises again. Furthermore, the expansionary policy generates inflation. If a monetary contraction is used to reduce inflation, the adverse effects on poverty offset even the temporary reduction in poverty during the earlier boom.

In the long run, monetary policy most directly affects average inflation and the variability of aggregate demand. Therefore, the important question from the perspective of monetary policymakers concerned with the condition of the poor is whether there is a link between these variables and poverty and inequality. We investigate such long-run relationships in the second section of the paper.

We use data for a large sample of countries from the 1970s and 1980s to see if there is a systematic relationship between poverty and the variables directly affected by monetary policy in the long run. We find that there are indeed important negative relationships between the income of the poor and both average inflation and macroeconomic instability. These relationships are quantitatively large and robust to permutations in samples and control variables.

Looking at the components behind the reduced-form correlations provides insight into the source of these relationships. Our own estimates and those in the literature suggest that high inflation and macroeconomic instability are correlated both with less rapid growth of average income and with lower equality. We also find that it is primarily the long-run link between monetary policy and the behavior of average income that is driving the negative correlations of both inflation and variability with poverty.

Researchers and policymakers should obviously interpret correlations such as the ones we report with caution. They could, for example, result from some third factor, such as education or government effectiveness, that affects both poverty and monetary policy. Nevertheless, they are certainly consistent with the notion that controlling inflation and output variability through sound monetary policy is likely to result in higher income for those at the bottom of the distribution in the long run. For this reason, we conclude that compassionate monetary policy is, most likely, simply sound monetary policy. Monetary policy that aims to restrain inflation and minimize output fluctuations is the most likely to permanently improve conditions for the poor.

I. THE EFFECTS OF MONETARY POLICY ON THE DOOR IN THE SHORT RUN

The channels through which monetary policy affects the poor

Expansionary monetary policy raises both output and inflation in the short run. These short-run effects of monetary policy can influence the well-being of the poor through three channels.

First, and most important, the rise in average income in a cyclical expansion directly reduces poverty. For a given distribution of income around its mean, an increase in the mean reduces the number of people below a fixed cutoff. That is, a rise in all incomes together increases the incomes of the poor, and raises some of their incomes above the poverty level. Since expansionary monetary policy raises average income in the short run, this is a powerful mechanism through which monetary policy can immediately benefit the poor.

Second, there may be cyclical changes in the distribution of income. The declines in unemployment and increases in labor force participation and in real wages in an expansion are likely to be concentrated disproportionately among low-skilled workers. Thus the income distribution may narrow. In this case, there are short-run benefits of expansionary policy to the poor beyond its effect on average income. On the other hand, transfers are less cyclical than labor income, and the poor receive a larger fraction of their income from transfers than do the remainder of the population. If this effect predominates, the income distribution could widen in a boom. In this case, the benefits of expansionary policy to the poor are smaller than what one would expect given the impact on mean income.

Third, the inflation created by expansionary monetary policy has distributional effects. Inflation can harm the poor by reducing the real value of wages and transfers. For example, the fact that real welfare benefits fell in the 1970s may have been partly due to inflation. The pension income of the poor, on the other hand, is insulated from inflation: well over 90 percent of the pension income of the elderly poor comes from Social Security, which is indexed (U.S. House of Representatives, 1996, Table A-10). Finally, unanticipated inflation benefits nominal debtors at the expense of nominal creditors. If the poor are net nominal debtors, inflation can help them through this channel.

With these general considerations in mind, we turn to the empirical evidence to examine the impact of cyclical fluctuations and inflation on poverty. We also examine these variables' impact on the distribution of income. Our approach follows such authors as Blinder and Esaki (1978), Blank and Blinder (1986), Cutler and Katz (1991), Blank (1993), and Blank and Card (1993). We differ from these authors in focusing on the absolute rather than the relative well-being of the poor, in emphasizing the distinction between unanticipated and anticipated inflation, and in considering more recent data.

Because the income measures that we examine do not include capital gains and losses, these data may miss some of the short-run effects of monetary policy on the poor. Therefore, after examining the impact of unemployment and inflation on poverty and income distribution, we examine the financial balance sheets of the poor to see if unanticipated inflation is likely to have any substantial effect on them through this channel.

Poverty and the macroeconomy

We examine the relationship of poverty with unemployment and inflation in the postwar United States. Because data on poverty and income distribution are only available annually, we use annual data throughout. Our basic sample period is 1969-94; this is the longest period for which all of the series we use are available. Our dependent variable is the poverty rate--that is, the fraction of the population living in households with incomes below the poverty level. We use the unemployment rate for men aged 20 and over as our cyclical indicator; for simplicity, we refer to this as "unemployment" in what follows. Our measure of inflation in year t is the change in the logarithm of the GNP deflator from the fourth quarter of year t-1 to the fourth quarter of year t. To separate inflation into its anticipated and unanticipated components, we use the inflation forecasts from the Survey of Professional Forecasters (formerly the ASA/NBER survey). Specifically, our measure of expected inflation in year t is the median forecast in November of year t-1 of inflation over the next four quarters.

Charts 1 through 3 show the basic relationships. Chart 1 is a scatter plot of the change in the poverty rate against the change in unemployment. There is a strong positive relationship. That is, increases in unemployment are associated with increases in poverty. Charts 2 and 3 are scatter plots of the change in poverty against the unanticipated change and the anticipated change in inflation, respectively. Chart 2 shows no clear relationship between changes in poverty and unanticipated inflation. Chart 3, on the other hand, shows a moderate tendency for poverty to fall when there are anticipated increases in inflation.

[CHARTS 1-3 OMITTED]

The corresponding regressions are reported in the first three columns of Table 1. The regression of the change in the poverty rate on the change in unemployment yields a t-statistic of almost seven. The point estimate implies that a rise in unemployment of one percentage point is associated with a rise in the poverty rate of 0.4 percentage points. The regression of the change in poverty on the unanticipated change in inflation produces a coefficient that is small and insignificant. Finally, the relationship between the change in poverty and the anticipated change in inflation is close to significant. The point estimate implies that an anticipated increase in inflation of one percentage point is associated with a decline in poverty of 0.2 percentage points.

Table 1

POVERTY AND THE MACROECONOMY

                                      (1)      (2)      (3)      (4)

Constant                              .01      .08     -.02     -.79
                                    (.15)    (.60)    (.16)   (1.39)
Change in unemployment                .44                        .49
                                   (6.91)                     (5.71)
Unanticipated change in
  inflation                                    .04               .03
                                             (.44)             (.52)
Anticipated change in inflation                        -. … 

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