Wealth Inequality and Financial Development: Revisiting the Symmetry Breaking Mechanism

Abstract

In an overlapping generations model with financial frictions and the fixed investment size requirement, Matsuyama (2004, Econometrica) shows that, in the absence of integrated financial markets, the world economy has a unique steady state, which is symmetric and stable in the sense that inherently identical countries converge to the same income level in the long run, regardless of their initial income level; financial globalization may break this symmetric steady state and lead to cross-country income polarization. He calls this phenomenon symmetry breaking and points out that financial underdevelopment is one of the necessary conditions. We revisit this result by introducing wealth inequality and the minimum investment requirement into his framework. Increasing wealth inequality strictly reduces the possibility of symmetry breaking; if wealth inequality exceeds a threshold value, symmetry breaking does not arise at all, regardless of the level of financial development. Thus, wealth inequality is an equally important factor as financial development in determining the possibility of symmetry breaking. We also address some practical issues in this framework, e.g., the conditions of financial integration, the domestic financial crisis and capital controls, and the world interest rate shocks and income volatility.