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### I. Introduction — framing and structure
- Macroeconomic volatility has considerable impacts on growth and inclusiveness; absence of inclusiveness can both cause and amplify macroeconomic volatility.
- Pre-GFC view: volatility driven primarily by productivity shocks as a driver of inequality (Krusell and Smith,1998; Quadrini and Rios-Rull, 2015).
- Post-GFC paradigm: causation can run from inequality to volatility and crises (Kumhof, Ranciere, and Winant, 2015; Mian and Sufi, 2018).
- New heterogeneous-agent macroeconomic models show aggregates and national well-being depend non-trivially on income and wealth distribution (Yellen, 2016; Ahn, Kaplan, Moll, Winberry, and Wolf, 2018).
- IMF policy practice increasingly incorporates distributional and inclusive-growth implications, including COVID-related financial assistance in excess of $100 billion disbursed to more than 80 countries in 2020.
- Paper structure:
  - Section II: impact of economic fluctuations on measures of inclusiveness (advanced vs developing economies).
  - Section III: effects of inequality on macroeconomic volatility and crises.
  - Section IV: role of fiscal, monetary, macroprudential, and exchange rate policies in supporting inclusiveness.

### II. Impact of macroeconomic volatility on inclusiveness — key findings

#### A. Advanced economies
- Empirical regularities and dynamics:
  - Higher output volatility tends to widen income disparities.
  - Earnings volatility in the United States is highly cyclical and closely tracks the unemployment rate, markedly so during the Great Recession.
  - Across U.S. counties, income volatility varies positively with volatilities of poverty and unemployment; cyclical components account for a significant share of their total volatility.
  - Recessions often lead to permanent output and income losses regardless of cause.
- U.S. earnings inequality (1969–2018) — measures and patterns:
  - Two measures: 90/50 ratio (top-end inequality) and 50/20 ratio (bottom-end inequality).
  - 90/50 ratio increases steadily without a marked cyclical pattern.
  - 50/20 ratio increases sharply in each recession; cumulative increase during recessions exceeds overall increase over 1968-2018.
- Business-cycle mechanisms:
  - Steep rises in layoffs during recessions followed by slow hiring and slower wage gains for bottom earners.
  - Hysteresis links cyclical fluctuations to trend movements; recessions can amplify long-run trends in earnings inequality.
  - Business cycle fluctuations can account for about 50 percent of the rise in U.S. wealth inequality and virtually the entire increase in income inequality between 1980 and 2015.
- Policy implication:
  - Welfare gains from stabilization policies are larger than traditional estimates because stabilization reduces income inequality; gains are larger under hysteresis due to delayed human-capital investment and R&D.

#### B. Developing economies
- Crisis frequency and severity:
  - Low-income and emerging-market economies experience more frequent crises and deeper recessions than rich countries.
  - Terms-of-trade shocks reduce investment in human and physical capital and adversely affect growth and inclusiveness.
- Commodity boom example (Latin America and the Caribbean, 2003-14):
  - Poverty declined by almost 19 percentage points; cyclical income volatility accounted for about 40 percent of the decline in poverty.
- Reversibility during slowdowns:
  - Study of 71 developing countries (1980-2014): reductions in inequality during growth upswings are largely reversed during slowdowns; unemployment, especially youth unemployment, is the main transmission channel.
- COVID-19 labor-income and poverty impacts:
  - International Labor Organization estimate: labor income losses (excluding income support) declined by 35 percent during the first three quarters of 2020 (from Q4 2019), a loss of 1 billion full-time equivalent jobs; equivalent to US$3.5 trillion or 5.5 percent of global GDP.
  - World Bank baseline: COVID-19 may have driven some 70 million people into extreme poverty (less than 1.90 US Dollars a day) under a baseline scenario of 5 percent global GDP contraction in 2020.
  - Downside scenario (8 percent global contraction in 2020): an additional 46 million join extreme poverty in 2020.
  - By comparison, extreme poor declined about 30 million between 2015 and 2019.

#### C. Economic crises and inclusiveness
- Crisis types and persistent losses (1960-2014):
  - Balance of payment crises: persistent output losses relative to pre-crisis trend as high as 5 percent.
  - Banking crises: persistent output losses as high as 10 percent.
  - Twin banking/balance of payment crises: persistent output losses as high as 15 percent.
- Distributional impacts:
  - Financial-sector crises have more adverse effects on inequality than other crisis types; pre-crisis credit booms, capital-flow swings, and loose lending standards increase household leverage—particularly among lower-income households.
  - Portfolio composition differences: rich households concentrated in stocks; middle class concentrated in real estate and highly leveraged.
  - GFC evidence: U.S. middle class maintained wealth share through housing gains pre-GFC but lost wealth when housing collapsed; stock market recovery boosted top wealth sooner.
  - Survey of 100,000 U.S. households: bottom 10 percent experienced a 70 percent drop in earnings relative to 2007 long after the recession end; top 10 percent experienced less than a 5 percent drop.
  - One study estimated the GFC added some 64 million people below the $2 a day poverty line.
- Sovereign debt crises — channels and outcomes:
  - Indirect distributional channels: low/negative growth, higher inflation and inflation instability, higher output volatility, large exchange rate devaluations, debt write-offs/haircuts.
  - Evidence: recessions often preceded by sovereign debt buildup; high debt predicts low/negative growth and higher unemployment.

#### D. Fiscal consolidation — effects and distributional incidence
- Definition and general effects:
  - Fiscal consolidation = tax increases and expenditure cuts to reduce fiscal deficits and improve sustainability.
  - Austerity measures negatively affect output and growth in the short run; effects depend on composition, persistence, anticipation, and cushioning by other policies.
- Multipliers:
  - Tax-based consolidations: multipliers around -2 to -3.
  - Spending-based consolidations: multipliers around or below one.
  - In developing countries: government consumption cuts have temporary output impact, but public investment shocks have larger and longer-lasting effects.
  - Kraay (2014) estimates fiscal spending multipliers around 0.4 for a large sample of developing countries (1970-2010).
- Distributional magnitudes:
  - Fiscal policy in advanced economies, on average, reduces income inequality (measured by the Gini coefficient) by about 33 percent.
    - Two-thirds of this reduction is achieved by public transfers; about one-third comes from progressive taxation.
  - Fiscal redistribution in Latin America, on average, reduces income inequality by about 10 percent.
  - Spending-based consolidations in advanced economies: average inequality increase about 2 percent; tax-based episodes: about 1 percent.
- Mitigating measures:
  - Design revenue measures targeted at higher-income segments.
  - Accompany broad spending cuts with targeted social benefits and subsidies to offset adverse distributional impacts.

### III. How inclusiveness affects macroeconomic volatility and crises

#### A. Paradigm shift: heterogeneity matters
- Post-GFC research emphasizes that income and wealth distribution affect macroeconomic aggregates and fluctuations.
- Drivers of the shift include rising inequality before the GFC, better data, computational capacity, and heterogeneous-agent models.
- Need for causal identification methods remains critical; many studies show associations but not strict causality.

#### B. Inequality’s impact on growth and volatility
- Empirical evidence mixed on inequality and growth:
  - Some studies find positive associations in the short run; others find negative or non-linear relationships.
  - Higher income inequality results in shorter, more fragile growth spells (higher output volatility); low inequality associated with faster, more durable growth.
- Mechanisms:
  - Credit market imperfections and unequal investment access can lower aggregate investment and produce endogenous permanent fluctuations in output, investment, and interest rates.
  - Weak institutions amplify inequality’s adverse effects on growth and volatility.
- Macro aggregates and inequality:
  - Rising wealth inequality in the U.S. since 1980 accounts for large parts of declines in trend-level real interest rates, productivity growth rates, capital-to-income ratios, and consumption-to-wealth ratios (per cited working paper).

#### C. Inequality and crisis risk
- Mixed empirical evidence on rising top income shares causing credit booms/crises:
  - Results depend on sample period, inclusion of the GFC, and extent of financial deregulation.
- Theoretical transmission (credit-demand channel):
  - Rising top income shares increase aggregate savings.
  - Wealthy lend to lower/middle-income households; greater savings lower interest rates.
  - Low interest rates encourage borrowing by lower/middle-income households to sustain consumption, raising household debt-to-income ratios.
  - Credit bubble → financial fragility → debt defaults → financial crisis → output collapse.
  - Post-crisis scarring: highly leveraged low-income households reduce purchases, slowing recovery.
- Alternative views:
  - Rising inequality exacerbates crises but may not be the fundamental cause; financial systems can be inherently fragile and crash without rising inequality.

### IV. Macroeconomic policies and inclusiveness — instruments, channels, and evidence

#### A. Fiscal policy — mechanisms and policy guidance
- Fiscal tools influencing inclusiveness:
  - Level and types of taxes; scale and composition of spending; size of the budget deficit and financing modalities.
- Redistribution channels:
  - Progressive income taxes reduce pre-tax inequality.
  - Direct cash transfers and in-kind transfers (education, health) reduce inequality and increase skills/social mobility long run.
- Stabilization and cyclicality:
  - Automatic stabilizers account for up to two-thirds of overall fiscal stabilization effort in advanced countries—twice the contribution in emerging market and developing economies.
  - Discretionary countercyclical fiscal policy can reduce volatility and favor inclusiveness if pro-poor.
  - Procyclical fiscal policies magnify cycles and harm inclusiveness.
- Determinants of procyclicality and reforms:
  - Causes include lack of access to credit in bad times, political pressures in good times, high public debt, limited fiscal space, and low-quality institutions.
  - Policy implications: strengthen institutions, build fiscal space during upturns, deepen safety nets to strengthen automatic stabilizers, and add countercyclical fiscal buffers.

#### B. Monetary policy — channels to inequality and evidence
- Objectives and trade-offs:
  - Central banks target low and stable inflation to promote high and sustainable growth.
  - Countercyclical monetary policy reduces business cycle fluctuations; many developing countries have transitioned toward countercyclical monetary policy.
- Distributional channels:
  - Expansionary policy can raise growth and employment, increase inflation (eroding real debt for debtors), reduce interest rates (benefiting borrowers) and increase asset values (favoring the wealthy). Net effect ambiguous.
- Empirical findings:
  - Study of 32 advanced and emerging market economies (1990-2013): expansionary monetary actions reduce income inequality; effects vary by cycle state and country characteristics.
  - U.S. evidence since 1980: contractionary monetary policy increased inequality in labor earnings, total income, consumption, and expenditures.
- Modeling insights:
  - Monetary rules emphasizing price stability redistribute toward rich households; rules emphasizing output stability redistribute toward poor households exposed to unemployment risk.
  - Three amplifying channels when marginal propensities to consume vary: earnings heterogeneity, Fisher channel (unexpected inflation), interest rate exposure.
- Research needs:
  - More general equilibrium heterogeneous-agent models and causal empirical work on monetary policy’s distributional impacts.

#### C. Macroprudential policy — purpose and mixed distributional evidence
- Purpose and instruments:
  - Limit systemic risk and the financial accelerator with instruments such as LTV, LTI, and DSTI caps.
- Complementarity with monetary policy:
  - Macroprudential policy enhances monetary policy effectiveness by reducing financial disruptions and the pressure to cut rates unduly.
  - Empirical evidence: macroprudential tightening associated with reduced credit growth; restrictive monetary policy enhances this impact and reduces transmission delays of macroprudential actions.
- Distributional evidence:
  - Limited and mixed: some studies find certain macroprudential measures associated with higher income inequality; others find acquisition LTV ratios contributed to wealth inequality while house price increases reduced it.
- Research needs:
  - Deeper examination of macroprudential tools’ distributional effects.

#### D. Exchange rate management — stabilization and distributional channels
- Regime trade-offs:
  - Flexible exchange rates tend to be more effective in stabilizing output and help recovery from commodity shocks and global recessions.
  - Pegs are associated with lower inflation, which can benefit the poor, and can discipline monetary policy.
  - Floating regimes with credible inflation-targeting frameworks can protect the poor by anchoring inflation at low levels.
- Large movements and balance-sheet effects:
  - Large depreciations can expand traded sectors relative to nontraded sectors and, depending on ownership and sectoral employment, may increase wealth and income inequality.
  - Balance-sheet mismatches and firm ownership structures can make outcomes ambiguous.
- Research needs:
  - Further work on how exchange rate policy amplifies or attenuates balance-sheet vulnerabilities and implications for volatility and inclusiveness.

### V. Conclusion — synthesis, policy priorities, and research agenda
- Mutual interaction:
  - Macroeconomic instability and inclusiveness interact through multiple channels; macroeconomic policies are key to promoting stability while minimizing adverse inclusiveness effects.
- Avoiding procyclicality:
  - Macroeconomic policies can be sources of aggregate fluctuations when frameworks and institutions are weak; avoiding procyclical policies is vital for inclusive growth.
- Lasting scarring:
  - Many temporary fluctuations have lasting scarring effects on unemployment, human capital formation, health, and earnings distributions—effects likely amplified by COVID-19.
- Policy recommendations for policymakers:
  - Watch for buildups of economic vulnerabilities in financial, fiscal, currency, monetary, and macroprudential domains and act to avoid them.
  - Strengthen institutions, build fiscal space, and deepen safety nets to improve automatic stabilizers and support countercyclical buffers.
- Research agenda:
  - Develop innovative methods and theory to establish causality between macroeconomic policies and inclusiveness, with attention to two-way relationships between inequality and the macroeconomy.
  - More work required on the distributional effects of monetary policy, macroprudential policy, and exchange rate policy.

*Source: wpiea2021081-print-pdf*

### References..............................................................................................................

### wpiea2021081-print-pdf - References..............................................................................................................

### I. INTRODUCTION
- Macroeconomic volatility has considerable impacts on growth and inclusiveness; absence of inclusiveness can both cause and amplify macroeconomic volatility.
- Pre-GFC view: volatility driven primarily by productivity shocks as a driver of inequality (Krusell and Smith,1998; Quadrini and Rios-Rull, 2015).
- Post-GFC paradigm: causation can run from inequality to volatility and crises (Kumhof, Ranciere, and Winant, 2015; Mian and Sufi, 2018).
- New heterogeneous-agent macroeconomic models show aggregates and national well-being depend non-trivially on income and wealth distribution (Yellen, 2016; Ahn, Kaplan, Moll, Winberry, and Wolf, 2018).
- IMF policy practice increasingly incorporates distributional and inclusive-growth implications, including COVID-related financial assistance in excess of $100 billion disbursed to more than 80 countries in 2020.
- Paper structure:
  - Section II: impact of economic fluctuations on measures of inclusiveness (advanced vs developing economies).
  - Section III: effects of inequality on macroeconomic volatility and crises.
  - Section IV: role of fiscal, monetary, macroprudential, and exchange rate policies in supporting inclusiveness.

*Key figure references: Figure 1. Output losses, employment losses, and income inequality; Figure 2. Earnings inequality and business cycles in the United States, 1967-2018.*

### II. IMPACT OF MACROECONOMIC VOLATILITY ON INCLUSIVENESS
#### A. Impact of volatility on inclusiveness in advanced economies
- Empirical regularity: higher output volatility tends to widen income disparities (Breen et al., 2005; Chauvet et al., 2019; Huang et al., 2015; Aye et al., 2019).
- Business-cycle fluctuations affect poverty and unemployment; earnings volatility in the United States is highly cyclical and closely tracks the unemployment rate, markedly so during the Great Recession (Carr and Wiemers, 2018).
- Across U.S. counties, income volatility varies positively with volatilities of poverty and unemployment; cyclical components account for a significant share of their total volatility (Camarena and others, 2019).
- The GFC: countries with larger output and employment losses in the initial aftermath registered greater increases in income inequality relative to pre-crisis averages (Figure 1).
- Recessions often lead to permanent output and income losses regardless of cause (Cerra and Saxena, 2008, 2017).
- U.S. earnings inequality (1969–2018):
  - Two measures: 90/50 ratio (top-end inequality) and 50/20 ratio (bottom-end inequality).
  - 90/50 ratio increases steadily without a marked cyclical pattern.
  - 50/20 ratio increases sharply in each recession; cumulative increase during recessions exceeds overall increase over 1968-2018.
- Business-cycle asymmetries: steep rises in layoffs during recessions followed by slow hiring in recoveries and slower wage gains for bottom earners (McKay and Reis, 2008).
- Business cycles with hysteresis link cyclical fluctuations to trend movements; recessions can amplify long-run trends in earnings inequality (Barlevy and Tsiddon, 2006).
- Evidence (Bayer et al., 2020): business cycle fluctuations can account for about 50 percent of the rise in U.S. wealth inequality and virtually the entire increase in income inequality between 1980 and 2015.
- Policy implication: welfare gains from stabilization policies are larger than traditional estimates because stabilization reduces income inequality; gains are larger under hysteresis due to delayed human-capital investment and R&D (Stiglitz, 2012; Cerra, Fatás, and Saxena, 2020).

#### B. Impact of volatility on inclusiveness in developing economies
- Low-income and emerging-market economies experience more frequent crises and deeper recessions than rich countries (Naoussi and Tripier, 2013; Cerra and Saxena, 2008, 2017).
- Terms-of-trade shocks reduce investment in human and physical capital and adversely affect growth and inclusiveness (Cavalcanti, Mohaddes, and Raissi, 2014).
- Commodity boom (2003-14) in Latin America and the Caribbean: poverty declined by almost 19 percentage points; cyclical income volatility accounted for about 40 percent of the decline in poverty (Camarena and others, 2019).
- Study of 71 developing countries (1980-2014, Hacibedel et al., 2019): reductions in inequality during growth upswings are largely reversed during slowdowns; unemployment, especially youth unemployment, is the main transmission channel.
- COVID-19 labor-income losses:
  - International Labor Organization estimate: labor income losses (excluding income support) declined by 35 percent during the first three quarters of 2020 (from Q4 2019), a loss of 1 billion full-time equivalent jobs; equivalent to US$3.5 trillion or 5.5 percent of global GDP (International Labor Organization, 2020).
- Pandemic and extreme poverty:
  - World Bank baseline: COVID-19 may have driven some 70 million people into extreme poverty (less than 1.90 US Dollars a day) under a baseline scenario of 5 percent global GDP contraction in 2020 (Mahler et al. 2020).
  - Downside scenario (8 percent global contraction in 2020): an additional 46 million join extreme poverty in 2020.
  - By comparison, extreme poor declined about 30 million between 2015 and 2019.

#### C. Impact of economic crises on inclusiveness
- Crises types: financial-sector, currency (balance of payments), and debt (public or private); twin crises more common for currency/banking and currency/debt than banking/debt (Laeven and Valencia, 2018).
- Persistent output losses relative to pre-crisis trend (1960-2014, Cerra and Saxena, 2008):
  - Balance of payment crises: as high as 5 percent.
  - Banking crises: as high as 10 percent.
  - Twin banking/balance of payment crises: as high as 15 percent.
- Financial-sector crises have more adverse effects on inequality than other crisis types; pre-crisis credit booms, capital-flow swings, and loose lending standards increase household leverage—particularly among lower-income households.
- Portfolio composition differences:
  - Rich households: portfolios dominated by stocks.
  - Middle-class households: portfolios concentrated in real estate and highly leveraged.
  - Housing booms can decrease wealth inequality; stock market booms primarily boost top wealth shares.
- GFC evidence:
  - U.S. middle class (50th–90th percentiles) lost income share to top 10 percent in four decades before the GFC but maintained wealth share through housing gains; GFC housing collapse caused middle-class wealth losses while stock market recovery boosted top wealth sooner.
  - Banking and currency crises tend to increase income inequality and poverty across countries (Baldacci et al., 2002; De Haan and an-Egbert Sturm, 2017).
  - Survey of 100,000 U.S. households (Almeida, 2020): bottom 10 percent experienced a 70 percent drop in earnings relative to 2007 long after the recession end; top 10 percent experienced less than a 5 percent drop.
  - One study estimated the GFC added some 64 million people below the $2 a day poverty line (Ravallion and Chen, 2009).
- Sovereign debt crises:
  - Arise from unsustainable debt paths and unwilling creditors; causes include rising interest rates, persistent fiscal deficits from shocks, or exchange rate devaluations raising foreign-currency debt costs.
  - Indirect distributional channels: low/negative growth, higher inflation and inflation instability, higher output volatility, large exchange rate devaluations, debt write-offs/haircuts.
  - Evidence: recessions often preceded by sovereign debt buildup; high debt predicts low/negative growth and higher unemployment (Kumhof, Ranciere, and Winant, 2015; IMF, 2017a; Mian and Sufi, 2018; Reinhart and Rogoff, 2010; Kim and Zhang, 2019).

#### D. Impact of fiscal consolidation on inclusiveness
- Fiscal consolidation = tax increases and expenditure cuts to reduce fiscal deficits and improve sustainability.
- General finding: austerity measures negatively affect output and growth in the short run; effects depend on composition, persistence, anticipation, and cushioning by other policies.
- Multipliers:
  - Tax-based consolidations: multipliers around -2 to -3.
  - Spending-based consolidations: multipliers around or below one.
- Explanations:
  - Expenditure-based consolidation may be less contractionary if households/investors anticipate lower future taxes and increase consumption/investment.
  - Tax distortions can affect labor supply, especially second earners and younger workers.
- Country-specific characteristics widen multiplier range: exchange rate regime, initial tax coverage, tax rates.
  - Negative effects of spending cuts larger under fixed exchange rates and higher debt levels.
  - Broadening the tax base can make tax-based consolidations less harmful than tax-rate increases (Dabla-Norris and Lima, 2018).
  - Tax multipliers could be essentially zero under relatively low initial tax rates (Gunter et al., 2017).
- Role of other policies: monetary easing can cushion consolidation impacts; at zero lower bound, support is constrained, risking self-defeating consolidations (Fatás and Summers, 2018).
- Developing countries: evidence limited; government consumption cuts have temporary output impact, but public investment shocks have larger and longer-lasting effects; output effects larger during recessions (Honda et al., 2020). Kraay (2014) estimates fiscal spending multipliers around 0.4 for a large sample of developing countries (1970-2010).
- Distributional effects:
  - Fiscal adjustments affect inequality via output/employment effects and distributional incidence of spending cuts and tax increases.
  - Spending-based consolidations in advanced economies: average inequality increase about 2 percent; tax-based episodes: about 1 percent (Woo et al., 2013).
  - Spending cuts often hurt lower-income groups more as redistribution is largely via government spending; cuts in social benefits, education, and health worsen inequality, especially long-term (Clements et al., 2015; Woo, 2013).
  - In developing countries, social spending is lower and in-kind spending often poorly targeted; indirect taxes dominate revenue and tend to be regressive (Fabrizio et al., 2017; Peralta-Alva et al., 2019).
- Mitigating measures:
  - Design revenue measures targeted at higher-income segments.
  - Accompany broad spending cuts with targeted social benefits and subsidies to offset adverse distributional impacts (Clements et al., 2015; Fabrizio et al., 2017).
- Research gap: further work needed on net effects of consolidation, particularly for developing economies.

### III. IMPACT OF INCLUSIVENESS ON MACROECONOMIC VOLATILITY AND CRISES
#### A. Macroeconomy and inequality: A paradigm shift
- Pre-GFC: view that income distribution did not matter for macroeconomic fluctuations.
- Post-GFC/new paradigm: inequality matters for the macroeconomy and vice versa (Ahn, Kaplan, Moll, Winberry, and Wolf, 2018).
- Drivers: rising inequality before the GFC, better data, computational capacity, and incorporation of heterogeneity in models.
- Need for causal identification methods (Nakamura and Steinsson, 2018; Gabaix and Koijen, 2020); many studies do not fully establish causality.

#### B. Impact of inequality on growth, volatility, and other macroaggregates
- Empirical findings on inequality and growth mixed:
  - Forbes (2000): positive association.
  - Panizza (2002): negative relationship for 50 U.S. states.
  - Banerjee and Duflo (2003): non-linear association.
  - Grigoli, Paredes, and Di Bella (2018): higher income inequality leads to lower growth in three-quarters of 77-country sample.
- Short-run studies (e.g., 5-year averages) tend to find positive association; results depend on methods, measures, frequencies, and functional forms.
- Inequality and durability of growth:
  - High income inequality results in shorter, more fragile growth spells (higher output volatility); low inequality associated with faster, more durable growth (Berg et al., 2018).
  - Mechanisms: relax credit market imperfections, reduce distortionary taxation, reduce political instability and uncertainty.
- Rising wealth inequality in the U.S. since 1980 accounts for large parts of declines in trend-level real interest rates, productivity growth rates, capital-to-income ratios, and consumption-to-wealth ratios (Lee, 2021).
- Capital market imperfections plus unequal investment access can generate endogenous permanent fluctuations in output, investment, and interest rates (Aghion, Banerjee, and Piketty, 1999). Policy implications: financial inclusion, tax policy to absorb idle savings, investment subsidies.
- Weak institutions amplify inequality’s adverse effects on growth and volatility; divided/polarized societies with fragile institutions experience sharper growth drops (Rodrik, 1999; Woo, 2011; Grigoli, Paredes and Di Bella, 2018).

#### C. Impact of inequality on economic crises
- Mixed empirical evidence on whether rising top income shares cause credit booms/crises:
  - Study of 14 advanced countries (1920–2000) found credit booms increased banking-crisis probability but no evidence top income shares led to credit booms (Bordo and Meissner, 2012) — sample excluded the GFC.
  - Including the GFC: higher top income shares positively associated with credit booms (Perugini et al., 2016); effect depends on extent of financial deregulation.
- Identifying exogenous changes in inequality remains difficult; many studies assess predictive power rather than strict causality.
- Slow-moving trends (rising top income inequality, prolonged low productivity growth) have predictive power for onset and severity of financial crises and are associated with slower recoveries (Kirschenmann, Malinen, and Nyberg 2016; Paul, 2020; Paul and Pedtke, 2020).
- Theoretical transmission mechanism (Kumhof, Ranciere, and Winant 2015; Rajan 2010; Mian and Sufi 2018):
  - Rising top income shares increase aggregate savings.
  - Wealthy lend to lower/middle-income households; greater savings lower interest rates.
  - Low interest rates encourage borrowing by lower/middle-income households to sustain consumption, raising household debt-to-income ratios.
  - Credit bubble → financial fragility → debt defaults → financial crisis → output collapse.
  - Post-crisis scarring: highly leveraged low-income households reduce purchases, slowing recovery.
- Alternative view (Piketty and Saez, 2013): rising inequality exacerbates crises but is not the fundamental cause; modern financial systems inherently fragile and can crash without rising inequality.

### IV. MACROECONOMIC POLICIES AND INCLUSIVENESS
- (Section begins in source; detailed analysis and policy prescriptions are contained in subsequent pages not included in this excerpt.)

*Source: wpiea2021081-print-pdf - References..............................................................................................................*

### Section II analyzed the adverse effects of macroeconomic instability – and specifically of

### wpiea2021081-print-pdf - Section II analyzed the adverse effects of macroeconomic instability – and specifically of

### Overview
- Recessions can have adverse long-run effects on inequality, but sufficiently aggressive policy responses can prevent or reverse these effects; historical example: the Great Depression’s post-crisis inequality decline attributed to “large political shocks and policy responses—in particular the tremendous changes in institutions and tax policies and rise of the welfare state—which took place in the 1930s–40s” (Piketty and Saez, 2013).
- Business cycle asymmetries and hysteresis imply macroeconomic policies can both stabilize the economy and raise the average level of economic activity, thereby reducing the natural level of unemployment (Dupraz, Nakamura, and Steinsson, 2020).
- The section provides an overview of how stabilization policies affect inclusiveness through multiple channels.

### A. Fiscal policy — findings and mechanisms
- Fiscal policy tools that influence inclusiveness:
  - Level and types of taxes.
  - Scale and composition of spending.
  - Size of the budget deficit and modalities of financing.
- Redistribution channels:
  - Tax side: progressive income tax structures reduce pre-tax income inequality.
  - Expenditure side: direct cash transfers (social security, disability payments, unemployment benefits, food stamps) and in-kind transfers (education, health) reduce inequality and, over the long run, increase skills and social mobility.
  - Financing: central bank financing of large deficits can increase the inflation tax, which can hurt the poor who hold more savings as cash.
- Empirical magnitudes:
  - Fiscal policy in advanced economies, on average, reduces income inequality (measured by the Gini coefficient) by about 33 percent.
  - Two-thirds of this reduction is achieved by public transfers; about one-third comes from progressive taxation.
  - Fiscal redistribution in Latin America, on average, reduces income inequality by about 10 percent.
- Effects of tax cuts:
  - Evidence from 18 OECD countries over the 1965-2015 period (difference-in-difference) finds major tax cuts for the rich increased income inequality as measured by the top 1 percent share of pre-tax national income; the effect remains stable in the medium term and shows no significant effect on economic growth and unemployment (Hope and Limberg, 2020).
- Stabilization and cyclicality:
  - Automatic stabilizers are efficient for fiscal stabilization; they account for up to two-thirds of overall fiscal stabilization effort in advanced countries—twice the contribution in emerging market and developing economies (IMF, 2015).
  - Discretionary countercyclical fiscal policy—raising taxes/reducing spending in booms and cutting taxes/increasing spending in recessions—can reduce macroeconomic volatility and favor inclusiveness, especially if measures are pro-poor (progressive tax-and-transfer, infrastructure, health, education).
  - Procyclical fiscal policies (expansions in booms, contractions in busts) magnify cycles and harm inclusiveness:
    - Brueckner and Carneiro (2017) show negative effects of terms of trade shocks are significantly higher with procyclical government spending.
    - Vegh and Vuletin (2015) show procyclical fiscal policy causes deterioration in poverty rate, income inequality, and unemployment in some Latin American and European countries.
    - Ouedraogo (2015) finds procyclical government investment is associated with higher inequality than procyclical government consumption.
- Determinants of procyclicality:
  - Causes include lack of access to credit markets in bad times, political pressures in good times, high public debt, limited fiscal space, and low-quality institutions (Aizenman et al., 2019; Frankel et al., 2013).
  - Bidirectional causation possible: high initial income inequality linked to greater fiscal policy volatility and procyclicality (Woo, 2011).
- Cross-country patterns:
  - About three-fourths of advanced economies can conduct countercyclical stabilizing fiscal policies; slightly more than a quarter of emerging market and developing economies have countercyclical fiscal policies (IMF, 2015).
  - A growing share of developing economies has been graduating from procyclical fiscal policies over the last two decades due to improvements in fiscal institutions (Frankel et al., 2013).
- Policy implications:
  - Strengthen institutions and build fiscal space during upturns to support countercyclical policy and move away from procyclicality.
  - Build deeper safety nets to strengthen automatic stabilizers and add countercyclical fiscal buffers.

### B. Monetary policy — findings and mechanisms
- Objectives and transmission:
  - Central banks target low and stable inflation to promote high and sustainable growth.
  - Countercyclical monetary policy (raising rates in booms, cutting in recessions) reduces business cycle fluctuations; many developing countries historically pursued procyclical monetary policies for exchange rate objectives, but about one-third have transitioned to countercyclical monetary policy over the last decade (Vegh and Vuletin, 2013).
- Channels to inequality and poverty:
  - Expansionary monetary policy can increase growth and employment (benefiting poor and middle classes), increase inflation (eroding real debt for debtors—often poorer), and reduce interest rates (benefiting borrowers but increasing asset values that favor the wealthy).
  - Net theoretical effect of monetary policy on inequality is ambiguous (Bernanke, 2015).
- Empirical evidence:
  - Study of 32 advanced and emerging market economies over 1990-2013 finds expansionary monetary actions reduce income inequality; effects vary by business cycle state and country characteristics, including share of labor income and fiscal redistribution (Furceri, Loungani, and Zdzienicka, 2018).
  - U.S. evidence since 1980 shows contractionary monetary policy systematically increased inequality in labor earnings, total income, consumption, and total expenditures; monetary shocks contributed non-trivially to historical cyclical variation in income and consumption inequality (Coibion et al., 2017).
- Heterogeneity and modeling:
  - Models with wealth and income heterogeneity clarify transmission channels:
    - A monetary policy rule emphasizing price stability redistributes toward rich households; one emphasizing output stability redistributes toward poor households exposed to unemployment risk (Gornemann, Kuester, and Nakajima, 2016).
    - When marginal propensities to consume vary, three channels operate: earnings heterogeneity, Fisher channel (unexpected inflation), and interest rate exposure; Italian and U.S. data suggest all three amplify monetary policy effects (Auclert, 2019).
  - Review finds mixed empirical findings on conventional monetary policy and inequality; consensus that higher inflation above some threshold increases inequality; effects of unconventional policies are unclear (Colciago, Samarina, and de Haan, 2019).
  - A study finds making consumption equality an explicit target for monetary policy, particularly with standard Taylor rules, can increase welfare compared with ignoring inequality (Hansen, Lin, and Mano, 2020).
- Research needs:
  - More general equilibrium models with heterogeneous agents and empirical work to establish causal impacts of monetary policy on inequality (Kaplan, Moll, and Violante, 2018; Colciago, Samarina, and de Haan, 2019).

### C. Macroprudential policies — findings and mechanisms
- Purpose:
  - Macroprudential policy limits systemic risk and ensures financial stability by addressing interconnectedness and the financial accelerator that amplify credit booms and busts.
- Instruments:
  - Caps on loan-to-value (LTV) ratios, loan-to-income (LTI) ratios, and debt service-to-income (DSTI) ratios are used to contain systemic vulnerabilities and the procyclical feedback between credit and asset prices.
- Complementarity with monetary policy:
  - Macroprudential policy can enhance monetary policy’s volatility-reducing effectiveness by lowering frequency/intensity of financial disruptions and the pressure to cut interest rates unduly during downturns.
  - Empirical evidence (37 emerging and advanced economies, 2000-14):
    - Overall macroprudential tightening associated with reduction in credit growth.
    - Restrictive monetary policy enhances the impact of macroprudential tightening on credit growth.
    - Monetary policy helps reduce the transmission delay of macroprudential actions (Garcia Revelo, Lucotte, and Pradines-Jobet, 2020).
- Macroprudential policy and inequality — limited and mixed evidence:
  - One study: higher concentration limits, macroprudential reserve requirements, and interbank exposure limits positively associated with higher market and net income inequality in the subsequent year; LTV and DTI limits positively associated with net inequality though not statistically significant (Frost and van Stralen, 2018).
  - Another study: high LTV ratios at acquisition contributed to wealth inequality, while house price increases reduced it; cost of credit not significantly linked to wealth distribution (Carpantier, Olivera, and Van Kerm, 2018).

### D. Exchange rate management — findings and mechanisms
- Role in stabilization and inclusiveness:
  - Exchange rate regime choices and specific movements affect inequality directly and indirectly via macroeconomic stability and balance-sheet effects.
  - The effectiveness of fixed vs. floating regimes in promoting inclusiveness depends on shock sources, financial links, monetary policy regime, and effectiveness of domestic prudential policies.
- Empirical findings:
  - Flexible exchange rate regimes tend to be more effective in stabilizing output (Hausmann and Gavin, 1996; Levy-Yeyati and Sturzenegger, 2003; Aizenman et al., 2018).
  - Flexible rates help recover more quickly from commodity price shocks and global recessions than pegs (Roch, 2019; Terrones, 2020; Carrière-Swallow et al., 2021) and mitigate transmission of global financial shocks to domestic markets (Obstfeld, Ostry, and Qureshi, 2019).
  - Pegs are associated with lower inflation, which may benefit the poor (Levy-Yeyati, 2019), and pegs discipline monetary policy and anchor inflation expectations.
  - Floating regimes with credible inflation-targeting frameworks can protect the poor by anchoring inflation at low levels.
- Large exchange rate movements:
  - Large depreciations tend to expand the traded goods sector relative to nontraded goods; if traded sectors are dominated by firms owned by the rich and the poor are concentrated in nontraded sectors, depreciations can increase wealth and income inequality (via firm values and reduced real wages in nontraded sectors).
  - Balance-sheet mismatches among firms can alter these effects and make outcomes ambiguous.
- Research needs:
  - Further work needed on how exchange rate policy amplifies or attenuates balance-sheet vulnerabilities and the implications for macroeconomic volatility and inclusiveness (Berg and Kpodar, 2019; Finger and Lopez Murphy, 2019).

### V. Conclusion — key messages and policy implications
- Macroeconomic instability and inclusiveness are mutually interacting through multiple channels; macroeconomic policies play a key role in promoting stability while minimizing adverse inclusiveness effects.
- Macroeconomic policies can themselves be sources of aggregate fluctuations when frameworks and institutions are weak; avoiding procyclical policies is vital for inclusive growth.
- Emerging macroeconomic paradigms incorporate heterogeneity in income and wealth and leverage “big data,” large distributional surveys, and labor market surveys, but gaps in causal knowledge remain.
- Evidence shows many temporary fluctuations have lasting scarring effects:
  - Recessions produce scarring on unemployment, human capital formation, and health, and skew earnings distributions—effects likely amplified by the COVID-19 pandemic.
- Policymakers should:
  - Watch for buildups of economic vulnerabilities in financial, fiscal, currency, monetary, and macroprudential domains and act to avoid them.
  - Strengthen institutions, build fiscal space, and deepen safety nets to improve automatic stabilizers and support countercyclical buffers.
- Research agenda:
  - More innovative methods and theory are needed to establish causality between macroeconomic policies and inclusiveness, with attention to two-way relationships between inequality and the macroeconomy.
  - More work required on the distributional effects of monetary policy, macroprudential policy, and exchange rate policy.

*Source: wpiea2021081-print-pdf*

### Chapter 2 in Global Financial Stability Report: Is Growth at Risk. October .

### Chapter 2 in Global Financial Stability Report: Is Growth at Risk. October .

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*Chapter 2 reference list from the PDF: wpiea2021081-print-pdf - Chapter 2 in Global Financial Stability Report: Is Growth at Risk. October .*

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_Source: https://www.imf.org/-/media/files/publications/wp/2021/english/wpiea2021081-print-pdf.pdf_