Sources of Inequality and Business Cycles: Evidence from the US and Japan

Weinvestigate (i) sources of inequality and business cycle fluctuations in the US and Japan and (ii) the effects of reducing inequality on business cycles. Developing a heterogeneous-agent business cycle model with unconstrained and hand-to-mouth households and various wedges to represent economic distortions, we estimate the model by the Bayesian methods. We find that, in the US, the labor market distortion specific to unconstrained households is the common factor that significantly impacts business cycles and consumption inequality, whereas there are no common factors in Japan. In both countries, the primary source of business cycles is distortions in aggregate productivity, and that of consumption inequality is household-specific labor market distortions. We assess labor market reforms and redistribution policy as means to reduce consumption inequality. Our findings imply that the effects of lowering inequality on business cycle volatility depend on the country and how it is done. We also find that labor market reform is welfare-improving in both countries while redistribution policy is not.