Working Paper（23-006E）Sources of Inequality and Business Cycles: Evidence from the US and Japan

The main objectives of this paper are twofold. The first is identifying the sources of inequality and business cycle fluctuations in the US and Japan. The second is investigating the effects of reducing inequality on business cycles. We develop a tractable heterogeneous-agent business cycle model with unconstrained (U) and hand-to-mouth (HtM) households. We also introduce wedges, which imply various types of distortions in economic activities, into the model following the business cycle accounting approach and estimate them by the Bayesian method. We focus on consumption inequality as inequality. We find that, in the US, the labor market distortions specific to the U households have significant impacts on both business cycles and consumption inequality, while the primary source of business cycles is the distortion in aggregate productivity, and that of consumption inequality is the labor market distortion specific to the HtM. In contrast, we find that no common factors significantly impact both business cycles and consumption inequality in Japan. In Japan, the key for business cycles is the distortion in aggregate productivity, and that for consumption inequality is the labor market distortions specific to U and HtM households. We also investigate the effects of reductions in consumption inequality on business cycle volatility through two types of experiments: (1) removing labor market distortions specific to two types of households, which are primary sources of consumption inequality, and (2) redistribution policy. Removing the labor market distortions increases output growth volatility in the US while it reduces in Japan. Removing cyclical consumption inequality by redistribution policy reduces output growth volatility in the US and increases in Japan. In contrast, reducing the level of consumption inequality from the estimated steady-state levels increases output volatility in both countries. However, the relation between the level of consumption inequality and output growth volatility is not monotonic. If consumption inequality is quite severe, a reduction in consumption inequality reduces output growth volatility.

Keywords: Inequality; consumption inequality; business cycle accounting; wedges; distortions; hand-to-mouth

JEL codes: E25; E32; E37