Does Inflation-targeting Policies Worsen Income Inequality in its Trading Partner?

Interest rate hike as an instrument for inflation-targeting has been adopted quite aggressively in recent times by the Fed Bank of the United States, which has some far-reaching implications for emerging market economies like India. In such a context, this article explores implications of interest rate hike by a large foreign country for wage inequality between skilled and unskilled workers in a domestic economy. We focus on the supply side channel: hike in foreign interest rate affecting wage inequality through its impact on domestic investment, capital formation and consequent changes in the composition of aggregate output. We show that the wage inequality worsens if capital-cost share in a composite traded good is larger than the capital-cost share in a skill-based export-good Z. Domestic policies such as credit expansion by changing the cash-reserve ratio and increase in money supply help mitigate this worsening wage-inequality effect of interest hike abroad. This issue assumes relevance because of rising concerns among the major central banks the world over about the income distributional impacts of monetary policies, whereas most of the recent income inequality trends seem to have been contributed largely by rising skill premiums.JEL Codes: E52, F41, F11, E24