Financial Market Integration and Income Inequality

Abstract

Benefits of financial market integration include cheaper and alternative options of saving and borrowing for households and entrepreneurs. In the global financial market, asset choices for households widen so that individuals can manage their idiosyncratic income risk more effectively. On the other hand, financial market integration makes investors who hold foreign assets more vulnerable to global financial shocks. In the recent financial crisis, financial market distress which initially arose in the U.S. had an enormous impact on the peripheral countries. This example shows that the strong shock propagation occurs via integrated financial markets. The existing literature shows that financial market integration has a sizable impact not only on business cycles in the short run, but also on economic growth in the long run. However, there has been little attention to income distribution, specifically in related to the financial market integration. In this paper, we fill the void in the literature by focusing on the following two stylized facts: income inequality has been exacerbated in most countries over the past two decades, and the financial market has been integrated across countries during the same period. In particular, we answer three research questions to investigate the relationship between the two facts. First, how does financial market integration affect income inequality? Second, how do financial market integration and financial market development interact to change income inequality? Third, what components do theoretical model need to explain the interaction effect of financial market development and integration on income inequality? We test hypotheses that the effect of financial market openness on inequality is conditional on the level of domestic financial market development when the financial market opens. An empirical study with panel data comprised of 174 countries for the period 1995-2017 finds that the overall effect of financial integration on income inequality is nonlinear. Financial market integration creates the intensive and extensive margins of credit supply which may depend on the development level of financial market disproportionally. This paper uncovers a novel empirical evidence that financial market integration and financial market development interact to change income inequality. When other things are controlled, the effect of financial market integration on in-come inequality depends on financial market development. In a country with underdeveloped financial market, income inequality gets worse as financial market opens. On the other hand, when financial market is highly developed, the effect of financial market openness on income inequality is mostly insignificant in a statistical sense. The results are still valid with different measures of financial market development, integration, and income inequality. We check that the results are robust as an endogeneity issue among financial market development and integration is controlled. We also suggest some important structures for the conventional economic model to account for our empirical finding as theoretical implications. Based on these implications, extensions of the conventional small open economy model with financial constraints having suggested components such as heterogeneous holdings of foreign assets across income and asset levels and entrepreneurial shocks will be necessary to understand an interaction of financial market openness and domestic market development on the distribution of income in a country. Our finding also echoes that studying an economic mechanism in which economic growth, financial market outcomes, and inequality are endogenously determined.