Business Cycles and Earnings Inequality

The author constructs a novel, quarterly measure of earnings inequality and document the following facts. First, shocks to productivity and government expenditure have significant effects on earnings inequality, while monetary policy shocks have little effect. Second, unanticipated innovations in earnings inequality, summarizing redistributive forces from the bottom to the top, substantially lower aggregate demand in a U-shaped manner. Finally, the power of stabilization policies increases with the level of inequality. These empirical results are rationalized by a tractable two-agent model, featuring countercyclical earnings risk, an endogenous extensive margin of being credit constrained, and decreasing relative risk aversion preferences.