Working Paper

Non-homothetic Demand Shifts and Inflation Inequality

Abstract: This paper shows that adverse macroeconomic shocks systematically increase inflation for low-income households relative to high-income households. I document two key facts: (i) during every U.S. recession since 1959, aggregate spending shifts toward products disproportionately purchased by low-income households (necessities); and (ii) relative prices of necessities rise during recessions. These patterns can be explained by a model with non-homothetic demand and a concave production possibility frontier: shocks that reduce expenditure induce households to reallocate spending from luxuries to necessities, raising their relative prices. I empirically show that this mechanism operates for both demand and supply shocks, using monetary policy and oil price news shocks. Incorporating this mechanism into a quantitative model reproduces most of the variation in necessity prices and shares from 1961 to 2024. The model shows that the fall in expenditure due to a recessionary shock similar to the Great Recession leads inflation to increase by more than 1.5 percentage points for low-income households relative to high-income households. The results suggest that low-income households are hit twice by adverse shocks: once by the shock itself and again as their price index increases relative to that of other households.

JEL Classification: E30; D12;

https://doi.org/10.17016/FEDS.2025.085

Bibliographic Information

Provider: Board of Governors of the Federal Reserve System (U.S.)

Part of Series: Finance and Economics Discussion Series

Publication Date: 2025-09-19

Number: 2025-085