Specializations, financial constraints, and income distribution

Abstract

We investigate how financial frictions affect across- and within-country income distributions by using a three-country dynamic general equilibrium model. In our model, the first and second countries specialize in producing (country-specific) intermediate goods and face financial constraints. The third country produces the final goods by using its own labor and intermediate goods purchased from the first and second countries. The financial markets of these countries are perfectly separated from each other, and the interest rates differ across countries. Our finding is that if the elasticity of substitution between the two intermediate goods is sufficiently high, the relaxation of financial constraints in the first (second) country decreases the second (first) country's income, whereas if the elasticity of substitution is sufficiently low, the relaxation of financial constraints in the first (second) country increases the second (first) country's income. We also find that the income inequality across the three countries is widened by the further relaxation of financial constraints in the country with higher financial development, regardless of the ranking of the per capita income between the first and second countries. Furthermore, the income inequality within the first or second country is reduced as the financial constraints in that country are relaxed.