Inequality Causes Recessions: A Fallout from Ramsey's Conjecture

Abstract

I show how the mechanisms of debt relief, redistribution and the uncertainty related to them could boil down to a discount rate shock for an aggregate representative agent. The mechanism hails from Ramsey's conjecture and the relationship between debt relief and the probability of repayment. To make this shock possible into a simple Real Business Cycle (RBC) model, I propose a two-capital setup, which provides an improved solution to the interest-rate-inelasticity issue than the usual investment adjustment costs by turning one type of capital into a fixed cost. Finally, I show the model's generality by adding wage rigidity and inflation. Considering the simplicity of the general equilibrium model, results provide a rich narrative for recessions.