Monetary transmission with income risk*

• Published date: 01 April 2023
• Author: Martin B. Holm
• Date: 01 April 2023
• DOI: http://doi.org/10.1111/sjoe.12516

Scand. J. of Economics 125(2), 441–460, 2023

DOI: 10.1111/sjoe.12516

Monetary transmission with income risk*

Martin B. Holm

University of Oslo, NO-0317 Oslo, Norway

martin.b.holm@outlook.com

Abstract

In periods of distress, observed and perceived income risk tends to rise. Does this heightened

income risk affect monetary transmission? This paper f‌irst shows that in partial equilibrium,

heightened income risk dampens the substitution effect of interest rate changes but amplif‌ies

the indirect income effect of wage changes. The effects are sizable in partial equilibrium. An

increase in income risk consistent with heightened risk during recessions affects interest rate

and wage responses by around one-third. However, because income risk dampens the effects of

interest rate changes but amplif‌ies the effects of wage changes, its effect is weaker in general

equilibrium, dampening monetary transmissions to consumption by around 11 percent.

Keywords: Income risk; monetary policy

JEL classif‌ication:D14; D52; E52

1. Introduction

This paper asks how income risk affects monetary transmission. This question

is important because perceived and observed income risk tends to rise in times

of distress.1If income risk dampens monetary transmission, monetary policy

might be a weaker tool when it is needed. Hence, business-cycle variation in

income risk can help to explain why monetary policy seems to be less potent

in recessions than in expansions (Tenreyro and Thwaites, 2016).

A change in income risk affects monetary transmission through two

channels. First, it affects the behavior of individuals by changing their optimal

responses to shocks. This channel operates regardless of whether the increase

in risk is actual or perceived. Second, higher income risk affects the distribution

of shocks and state variables by, for example, affecting the level of inequality

and thus how the economy responds to monetary policy. This paper focuses

*I thank two anonymous referees for excellent comments and suggestions. I would also like

to thank SeHyoun Ahn, Simon Galle, Even Hvinden, Ragnar Juelsrud, Benjamin Moll, Gisle

J. Natvik, Plamen Nenov, Morten O. Ravn, Kjetil Storesletten, Tommy Sveen, and various

conference and seminar participants for insightful comments and discussions.

1See, for example, Storesletten et al. (2004) (higher standard deviation of income in recessions),

McKay (2017) (more long-term earnings losses in recessions), and Guvenen et al. (2014)(more

left-skewness in recessions).

c

2022 The Author. The Scandinavian Journal of Economics published by John Wiley & Sons Ltd on behalf of F¨

oreningen

f¨

or utgivande av the SJE.

This is an open access article under the terms of the Creative Commons Attribution-NonCommercial-NoDerivs License,

which permits use and distribution in any medium, provided the original work is properly cited, the use is non-commercial

and no modif‌ications or adaptations are made.

442 Monetary transmission with income risk

exclusively on the f‌irst channel to isolate the impact of higher perceived

income risk on monetary transmission.

To understand how income risk affects monetary transmission, Section 2

f‌irst investigates theoretically how income risk affects non-durable

consumption responses to interest rate and wage changes for an individual

household. The starting point is a consumption-saving problem in an

incomplete-markets setting with idiosyncratic income risk. The household

consumes, saves, and borrows but lacks insurance against the idiosyncratic

income risk it faces. In this framework, Section 2explores how a household

responds to changes in the interest rate and wage, and how these responses

depend on the level of income risk. The main result is that income risk

dampens the consumption response to interest rate changes but amplif‌ies the

consumption response to wage changes.

Sections 3and 4next assess whether income risk might have quantitatively

relevant effects on monetary transmission. The f‌irst step is to evaluate whether

each channel derived theoretically might be quantitatively relevant in a partial

equilibrium setting. Section 3simulates individual consumption responses to

interest rate and wage change in two cases: low income risk and high income

risk. The high-risk case is computed as the responses to interest rate and

wage changes with the policy functions consistent with higher income risk.2

The difference between the two cases reveals the isolated impact of higher

perceived income risk on the consumption responses to interest rate and wage

changes, holding everything else constant. The second main contribution lies

here. Consistent with the theoretical predictions, an increase in income risk

of a similar magnitude as the change in risk from expansion to recession

from Storesletten et al. (2004) dampens a household’s sensitivity to short-run

interest rate changes by around one-third but amplif‌ies the sensitivity to

wage changes by around one-third. Hence, income risk has potentially sizable

effects on interest rate and wage sensitivity. However, the two effects might

partially cancel out because monetary policy affects consumption through

interest rates and wages.

The main drawback of the theoretical results in Section 2and the

quantitative exploration in Section 3is that they are limited to a partial

equilibrium setting. Exploring this question in general equilibrium is important

for two reasons. First, income risk affects several monetary transmission

channels, as explained above. Second, prices can move endogenously to

2The impulse responses in the high-risk case are def‌ined as the difference between the responses

to two shocks (higher perceived income risk and monetary policy) minus the response to higher

perceived income risk in isolation. Note that this has nothing to do with countercyclical or

procyclical income risk. It is merely a way to ensure that the initial conditions of the two cases

are the same. The responses are similar (with opposite sign) if one considers the case with lower

income risk.

c

2022 The Author. The Scandinavian Journal of Economics published by John Wiley & Sons Ltd on behalf of F¨

oreningen

f¨

or utgivande av the SJE.