Distributional Effects of Growth and the Elasticity of Substitution

Abstract

Reforms that promote economic growth have also an impact on the distribution of capital and income. I consider the effect of a rise in the elasticity of substitution between capital and labor and understand it as liberalization. To evaluate its effects, the normalized CES functions by Klump and de La Grandville (2000) are introduced. A rise in the elasticity of substitution may have an immediate impact on wages. Dynamic effects are studied in the Ramsey model with heterogenous agents by Caselli and Ventura (2000). The existence of a trade-off between growth and equality in liberalizing the economy depends crucially on the choice of the point of normalization. Inequality tends to increase, if an initially low economic flexibility is combined with a high share of capital income, high risk aversion or a wage rate close to the subsistence level. While inequality in a liberalized economy may be higher in the long-term, increases in absolute poverty are compensated quickly.