The relationship between income distribution and aggregate demand in monetary policy analysis is rarely investigated. Yet, in Chapter 19 of The General Theory of Employment, Interest and Money, Keynes (1936) notes that a reduction in nominal wages will involve a redistribution of income among members of the community. Specifically he notes that “the transfer from wage-earners to other factors is likely to diminish the marginal propensity to consume”. If rentiers are richer than entrepreneurs, this redistribution of income will have unfavorable effects on output. The idea that nominal wage reduction will stimulate output is based on the hope that investment would improve in the light of a rise in the marginal efficiency of capital or a decrease in the interest rate due to the liquidity effect of a reduction in prices.

Given the level of labor productivity, since nominal wage changes lead to price changes, income distribution will be affected, provided prices and nominal wages adjust at different speeds. However, the role of income distribution in determining aggregate demand—whilst well-known in Keynesian monetary policy analysis—is usually ignored in the small macro-models similar to the ones by Svensson (1997) and Ball (1999). Therefore, from a theoretical point of view, it can be argued that the IS-curve in these models is misspecified, which would necessitate an explicit modeling of nominal wage and price adjustment processes. By introducing income distribution in this fashion, an additional channel throughwhich monetary shocks affect real aggregates is opened, thus paving a way to a better
understanding of the monetary transmission mechanism. There are encouraging signs in this direction. Some authors have now turned their attention to the explicit treatment of wage dynamics and the implications of nominal wage inertia for monetary policy1. Their general findings are—sluggish nominal wage adjustment plays a major role in generating aggregate fluctuations and that nominal wage inertia produces a larger persistence of monetary shocks on real variables than could be produced when only prices are assumed to be sticky. The empirical strength of models that incorporate both nominal wage and price inertia is highlighted by Woodford (2003, Chapter 3). However, for a model with sluggish nominal wages to fit the data, it must allow for a procyclical
real wage. This can be achieved if nominal wages are allowed to adjust faster than prices in response to real economic activity in the goods market.