Demand Composition and Income Distribution

This paper highlights how changes in the composition of demand affect income dispersionin the short run. We first document how the share of aggregate spending dedicated tolabour-intensive goods and services shrinks (expands) during downturns (booms), andargue that this contributes to the observed pro-cyclicality of employment and output inlabour-intensive industries. Using a two-sector general equilibrium model, we then assesshow this demand composition channel influences the cyclical properties of the incomedistribution. Consistent with empirical evidence, we find income inequality to be countercyclicaldue to changes in the level of employment and (to a lesser extent) relative factorprices. The model also shows that wealth redistribution policies can potentially involve atrade-off between equality and output, depending on how they affect the composition ofaggregate demand.