Distributional Consequences of Monetary Policy in Emerging Economies: Dollarization, Domestic Inflation, and Income Divergence

Abstract

This paper explores the distributional effects of monetary policy in the context of a small open economy. Emerging markets are structurally different from developed economies. They are generally associated with greater financial frictions, underdeveloped financial markets, as well as both a high average level of dollarized assets and unequal access to them, among others. Thus, distributional effects of monetary policy in emerging economies require additional specifications. In particular, I show that wealthy households (represented by the top 10% of the income distribution), who are more able to save in foreign currencies, gain in purchasing power of their incomes by hedging against domestic inflation. At the same time, the poor households (represented by the bottom fifty percent of the income distribution) retain a larger share of liquid assets denominated in domestic currency, thus experiencing a greater burden of local currency inflation. I also show that contractionary monetary policy is associated with periods of higher income inequality in emerging markets that is likely to exacerbate the damaging impact of inflation on the bottom groups of the income distribution.