The Impacts of Sector Growth and Monetary Policy on Income Inequality in Developing Countries

Abstract

Using a cross-country panel of 92 developing countries over the period 1990-2014, this paper examines the impacts of sector growth on income inequality. Most low-income people in developing countries are involved in agriculture and related industries, and directly utilize natural resources. The question is what policy instruments are efficient to reduce income inequality. The main objectives of monetary policy aim to maintain price stability, improve sector growth, and create employment. But, empirical evidence indicates that the impact of these policies to reduce income inequality have not been efficient, and monetary policy always dominates fiscal policy for rising or falling income inequality during a certain period, which in turn influences the inflation and real output in the countries. While inflation is a major variable to affect the purchasing power of low-income people, we examine the existence of linear and nonlinear linkages between inflation as a proxy of monetary policy and income inequality in line with testing validity of the Kuznets hypothesis to assess the monetary policy efficacy. The statistically significant finding shows that first agricultural growth and then industrial growth have a dominate impact in reducing income inequality in our sample. But, the service sector growth has positive effects. The results confirm the existence of Kuznets inverted 'U' hypothesis for industry growth and Kuznets 'U' hypothesis for service sector growth. Using an error correction model for analyzing the short- and long-run relationship between income inequalities, sector growth, and inflation, we find that sector growth and inflation affect income inequality in the long-run.