U.S. Monetary Policy and Income Inequality in Small Open Economies

Abstract We study the distributional and welfare implications of U.S. monetary policy shocks in a small open economy under the classic rules of an exchange rate peg and inflation targeting. In a model with heterogenous agents, we show that contractionary (expansionary) monetary policy shocks in the U.S. decrease (increase) inequality under both regimes. The magnitude of the fall (rise) in inequality is, however, higher under inflation targeting. Further, we show that the results on welfare are critically dependent on wage rigidity. The model’s implications are supported by empirical evidence. Based on the local projection method, with an unbalanced panel, we find that a 1% increase in Fed fund rates cumulatively, over a period of three years, lowers income inequality by approximately 0.3% under inflation targeting and 0.13% under a pegged regime