Unequal Cost of Living Across Households and Its Impact on Monetary Policy Power

The paper shows that poorer, high-spending households face more volatile and cyclical inflation because they consume goods with more flexible prices, which weakens the real impact of monetary policy. Ignoring this inequality in the cost of living leads central banks to overestimate policy effectiveness and potentially target the wrong inflation measure.

A study, written by researchers at the International Monetary Fund (IMF) Research Department, uses evidence from U.S. institutions such as the Bureau of Labor Statistics and long-running academic datasets, including the Panel Study of Income Dynamics, to ask a simple yet powerful question: Do all households experience inflation in the same way? The answer, the authors show, is no, and that difference has major consequences for how monetary policy works. While much economic research focuses on how interest-rate changes redistribute income, this paper highlights a less visible but equally important channel: inequality in the cost of living itself.

Who Faces Higher Inflation and Why

Households differ sharply in what they consume. Those with high marginal propensities to consume, mainly renters and households with mortgages, spend more on goods such as gasoline, vehicles, and other items whose prices change frequently. Wealthier homeowners, who tend to have lower MPCs, spend relatively more on services like healthcare and insurance, where prices are slower to adjust. Because of these differences, high-MPC households face more flexible prices overall. The paper shows that about 23 percent of prices in their consumption baskets change in a typical month, compared with roughly 20 percent for low-MPC households. This seemingly small gap turns out to be economically important.

Inflation Is Unequal and Cyclical

Because they consume more flexible-price goods, high-MPC households experience inflation that is both more volatile and more closely tied to the business cycle. When the economy heats up and overall inflation rises, these households see their cost of living increase faster than that of wealthier households. When inflation falls, their prices also drop more quickly. The authors capture this pattern using an “inequality price index,” which measures the inflation gap between low- and high-MPC households. Historically, this gap moves strongly in the opposite direction of aggregate inflation, meaning inflation inequality widens precisely during inflationary episodes.

Monetary Policy Can Weaken Itself

The paper then shows why this matters for monetary policy. Using detailed data and several methods to identify policy shocks, the authors find that after an expansionary monetary policy move, inflation faced by high-MPC households rises about 40 percent more than inflation faced by low-MPC households. This is crucial because high-MPC households are the ones most likely to increase consumption when their real income rises. If monetary easing raises their cost of living quickly, it reduces their real purchasing power and blunts their spending response. To explain this mechanism, the authors build a multi-sector economic model in which households differ both in financial constraints and in what they consume. In this framework, unequal inflation directly redistributes real income across households. Quantitatively, the model shows that ignoring cost-of-living inequality leads economists to overestimate the power of monetary policy by about 15 percent.

Rethinking Optimal Monetary Policy

The consequences extend beyond short-term policy effects to the design of optimal monetary policy itself. Once households face different inflation rates and cannot fully insure against them, even a perfectly flexible-price economy becomes inefficient. Differences in the cost of living distort labor supply and consumption decisions, creating inequality that varies over time. As a result, stabilizing the output gap, long considered the gold standard of monetary policy, is no longer enough to achieve the best social outcome. The paper shows that this classic “divine coincidence” only holds if all households consume identical baskets of goods, a condition clearly violated in reality. In some cases, reducing inequality requires central banks to pay more attention to inflation in flexible-price sectors or even to stabilize headline inflation rather than focusing narrowly on core inflation.

The Big Takeaway

The central message of the paper is clear and practical. Inflation is not the same for everyone, and this inequality changes how monetary policy works and how it should be designed. By overlooking differences in households’ cost of living, central banks risk overstating the effectiveness of their actions and choosing policy targets that unintentionally worsen inequality. Recognizing and measuring cyclical inequality in inflation, the authors argue, is essential for understanding monetary transmission and for designing policies that are both effective and socially efficient.