Financial development, income and income inequality

Abstract

The aim of this paper is twofold. Firstly, we present a model in which both income and income inequality are jointly determined in a counter-cyclical manner via self-fulfilling expectation. We argue that multiple equilibria can arise in the presence of inelastic labor demand, a minimum investment requirement, and imperfections in the credit market. In one equilibrium, the market wage and labor income are both low. Young agents who become entrepreneurs work harder and save more than young agents who become depositors. As a result, the equilibrium is characterized by low-income and high-income inequality. In another equilibrium, the market wage and labor income are both high. Young agents supply the same amount of labor and save the same. As a result, the equilibrium is characterized by high-income and low-income inequality. Secondly, we present different dynamic scenarios predicted by the model and analyze the role of self-fulfilling expectations. The paper ends by providing some policy recommendations on how the coordination of agents’ expectations about labor market conditions and how improvements in financial development may affect the long-run income and income inequality.