INEQUALITY IN MACROECONOMICS

Vincenzo Quadrini
University of Southern California, José-Víctor Ríos-Rull
University of Minnesota
Federal Reserve Bank of Minneapolis

1 Some facts on income and wealth distribution
2 The irrelevance of income and wealth inequality in the neoclassical growth model
3 Modeling the sources of macro inequality
    3.1 Stationary theories of earnings and wealth inequality
    3.2 The level of development affecting inequality
    3.3 Business cycles affecting inequality
4 Macroeconomic consequences of inequality
    4.1 Inequality affecting growth
    4.2 Inequality affecting the business cycle

In a handbook devoted to income distribution, a chapter devoted to macroeconomics should start by clarifying the connection between macroeconomics and inequality. Although the focus of macroeconomics is on the aggregate economy, the dynamics of aggregate quantities may depend on their distributional characteristics among individuals, households, and other institutions. Thus, understanding the factors that affect the distribution of resources is of central interest for macroeconomic studies. At the same time, the aggregate dynamics may affect the distribution of aggregate quantities. Thus, understanding the factors that affect the macro-economy is also important for understanding the sources of inequality. It is not surprising then that the interconnection between inequality and the macro-economy has a long tradition in macroeconomic studies. The goal of this chapter is to review some of the most influential contributions.

In presenting the various contributions, we find convenient to separate two main branches of macroeconomic studies. One branch is primarily interested in understanding the sources or causes of inequality, while the other is concerned with the consequences of inequality for the aggregate performance of the economy. Such a distinction is not always applicable, yet it provides a natural organization of the literature. We will also find convenient to separate studies that are primarily interested in economy growth from those focusing on business cycles.

Throughout the presentation of the various contributions, we will use a unified theoretical framework that, although stylized, it is sufficiently general to encompass, as special cases, the various theories proposed in the literature. Before doing so, however, it will be convenient to describe some of the salient empirical features of income and wealth inequality in the U.S. This will serve as a reference for the presentation of the various theories in subsequent chapters.

1 Some facts on income and wealth distribution

This draws from Díaz-Giménez, Glover, and Ríos-Rull, [2011] and Budría, Díaz-Gimenez, Quadrini, and Ríos-Rull, [2001]

2 The irrelevance of income and wealth inequality in the neoclassical growth model

A first question is what standard theory has to say about income and wealth distribution. For standard theory we mean the neoclassical growth model. The answer is simple: it says nothing. In an importance article by Chatterjee, [1994], reiterated later by Caselli and Ventura, [2000], it is shown that any permanent difference in the distribution of earning abilities is associated with an initial distribution of wealth that is self perpetuating. Furthermore, aggregate quantities are independent of the distribution. Therefore, within this model, we can focus on a representative agent.

Central to this result is the assumption that markets are complete. The relaxation of this assumption is thus one of the approaches adopted by many (although not all) studies of income and wealth inequality that we will review in this chapter.

3 Modeling the sources of macro inequality

Inequality requires some fundamental form of heterogeneity either in initial endowments, technology, or preferences. An example of differences in preferences is the assumption that some agents have higher tolerance to risk than other agents. As a result of preference heterogeneity, agents undertake different economic activities earning different incomes and accumulating different levels of wealth. Another example is that some people are more patient than others which results in higher levels of wealth over time.

From the point of view of technology we can think that agents are endowed, permanently, with different amounts of skills or efficiency units of labor, or even different amounts of skills. The problem with this permanent differences in either preferences or technology is that we are not explaining how they are generated in the first place. Furthermore, they do not change over time.

Many studies consider environments where agents are ex-ante identical but ex-post heterogeneous. For example, in the Bewley, [1986] economy, all agents have the same preferences and face the same endowment process. However, since the idiosyncratic realizations of endowments are not insurable, endogenous savings generate a complex distribution of wealth. In these models inequality is a consequence of market incompleteness which limits the ability to insure risks.

We will look first at the literature that consider models where persistent yet random shocks generate unique predictions about the earnings and wealth distributions in absence of aggregate uncertainty.

3.1 Stationary theories of earnings and wealth inequality

The limited insurability of risk also means that agents have an incentive to save in order to smooth their consumption. Therefore, the ex-post inequality in economic outcomes also translate in ex-post inequality in asset holdings or wealth. This type of ex-post inequality has been widely studied in models where the risk was on endowments or earnings and agents could save only in the form of non-state contingent assets. Examples are Huggett, [1993], \.Imrohoroglu, [1989], Aiyagari, [1994], Carroll, [1997]. As shown in Quadrini and Ríos-Rull, [1997], these models can generate significant concentration of wealth but still short of the high degree of concentration we observe in the data, especially at the top of the wealth distribution.

Recognizing this, successive studies have extended these models to improve the ability to generate greater wealth inequality. Among these approaches are the addition of special earning risks (Castañeda, Díaz-Giménez, and Ríos-Rull, [2003], entrepreneurial risks Quadrini, [1997] and Cagetti and Nardi, [2006], endogenous accumulation of human capital (Terajima, [2006]) and stochastic discounting (Krusell and Smith, [1998]). Since in these models inequality is endogenous, the degree of wealth concentration can be affected by policies. This opened the way to studies that investigated the importance of taxation policies for wealth inequality. An example is Díaz-Giménez and Pijoan-Mas, [2011], and Cagetti and Nardi, [2009]).

3.2 The level of development affecting inequality

Other approaches abstract from risk and focus on ex-ante heterogeneity in skills or human capital. Since growth-enhancing technologies may not be neutral in affecting the productivity of various skills, technological progress could generate important changes in the distribution of incomes. This literature was stimulated by the observation that, since 1980, wage inequality among different education groups has widen in many industrialized countries. Katz and Murphy, [1992] show that this increase is due to a raising demand of skilled labor. Krusell, Ohanian, Ríos-Rull, and Violante, [2000] propose an explanation for the increasing demand of skilled labor based on the introduction and development of new technologies that are more complementary to skilled labor (skill-biased technologies).

The hypothesis of skill biased technologies is a compelling explanation for the increasing wage premium that started at the beginning of the 1980s. This also raises the question of why the ratio of skilled versus unskilled workers has not increased more rapidly during this period. To addressed this question, a model that makes endogenous the accumulation of skills is needed.

The technological innovations introduced in the 1970s seem to have affected the economy in other respects. Greenwood and Jovanovic, [1999] and Hobijn and Jovanovic, [2001] assume that new information technologies required a level of restructuring that incumbent firms could not face. As a result, their stock market value dropped. This is another form of redistribution in the sense that the owners of incumbent firms lose market value to the owners of the new firms.

More recently, we have observed a further increase in inequality that is especially concentrated in the very top of the distribution. Furthermore, the increase in inequality seems to be concentrated in certain professions, namely managerial occupations in the financial sector. Several studies have associated this recent increase in inequality to technological innovations that took place in the financial sector. We will review some of the most influential theories proposed in the literature including those that emphasize the inefficiency associated with the expansion of the financial sector.

One of the most known regularity between inequality and growth is the Kuznets curve. According to Kuznets, in the early stage of human development, income inequality is relatively low. As the economy industrializes and the workforce moves away from agriculture, the distribution of income tend to widen. At some point this tendency reverses. Although more recent evidence does not support the Kuznets curve hypothesis (for example this is contradicted by the widening income inequality observed in the United States since early 1980s), the original empirical finding of Kuznets, [1955] stimulated a large body of research activity.

Data collected during the 1980s and 1990s show that there is a negative correlation across countries in the degree of income inequality and economic growth. See Benabou, [1996] and Perotti, [1996]. But correlation does not imply causation, and there are good reasons to think that the causation can go in both directions: slow growth could generate greater inequality and equality could lead to faster growth. In this section we focus on the first channel, from growth to inequality.

Technological change is an important factor underlying economic development. However, for technological progress to take place, economic agents need to undertake innovative activities that involve risks that cannot be insured. The limited insurability of risk implies that only few agents are successful and this generates inequality. We would then expect that faster growth is associated with greater ex post inequality.

3.3 Business cycles affecting inequality

A well known feature of the business cycle is that capital income share is pro-cyclical while the labor income share is counter-cyclical. To the extend that the income of some agents are mainly in the form of capital incomes while for others are in the form of labor incomes, the business cycle has important implications for inequality.

Besides the fact that capital income share is slightly pro-cyclical, the impact of the business cycle on inequality is complex. On the one hand, workers tend to lose their jobs in recession and this increases inequality. On the other hand, profits and capital gains are squeezed in recessions. Since the receivers of these incomes are typically located at the very top of the distribution, this should reduce inequality. In this section we will review some of the studies proposed in the literature that investigate the connection between business cycle and inequality. (Castañeda, Díaz-Giménez, and Ríos-Rull, [1998]).

4 Macroeconomic consequences of inequality

The central interest of macroeconomics is in the study of the aggregate economy. Although the focus is on aggregated outcomes, aggregation may be highly non-linear. Thus, how resources are distributed matters for economic outcomes. For example, if agents have different saving rates, a higher concentration of incomes in the hand of those with higher propensity to save increases aggregate savings.

4.1 Inequality affecting growth

One of the channels through which inequality affects growth is through the political and institutional system. A new series of studies in the 1980s, pioneered by Romer, [1986] and Lucas, [1988], developed a new class of models in which government policies could have a significant impact on the long-term growth of the economy (endogenous growth models). Given the importance of government policies for long-term growth, it became important to understand the forces and mechanisms underlying the choice of policies. This stimulated a new series of studies in political economy which tried to understand the political choice of policies that were relevant for economic growth. Since many policies have redistributive consequences, the degree of inequality plays a central role in the choice of policy. Thus, an influential literature developed investigating how inequality affects the choice of policies which in turn affects economic growth. The main conclusion of this literature is that inequality impairs the economic potential of a country because voters will demand more redistribution through distortionary taxes. Some contributions in this literature are Persson and Tabellini, [1994], Alesina and Rodrik, [1994], Krusell and Ríos-Rull, [1996], Krusell, Quadrini, and Ríos-Rull, [1997].

Several theories envision a beneficial effect of redistributive taxes. A central ingredient is the presence of financial constraints. If certain agents are financially constrained in their choice of productive investment, redistribution may provide extra resources used to finance more investment in growth-enhancing activities. At the same time, a redistributive system provides an implicit mechanism for income smoothing (a person pays high taxes when he or she earns high profits but receives payments in case of losses), and therefore, it provides insurance. If entrepreneurs are risk averse, this encourages more investment.

A similar mechanism applies to investment in education or human capital. In this case the relaxation of the constraint could arise through direct redistributive policies or public financing of education. Examples include Glomm and Ravikumar, [1992], Galor and Zeira, [1993], Banerjee and Newman, [1993] and Aghion and Bolton, [1997].

Another group of studies emphasize social conflict and expropriation as in Benhabib and Rustichini, [1996] while others develop a theory in which income concentration can have positive effects on economic growth because this creates sufficient demand for the introduction of products with growth enhancing properties (Murphy, Shleifer, and Vishny, [1989]).

In the previous section we have emphasized the role of incomplete markets for wealth inequality. The idea is that the limited insurance of risk generates ex-post heterogeneity in asset holdings. This mechanism is also important for economic growth. As a result of the limited insurance of risks, agents have an incentive to save more and accumulate more capital as in Aiyagari, [1994]. The higher accumulation of capital implies that the economy produces more. With constant returns to aggregate capital the economy experiences faster long-term growth. Therefore, this mechanism generates a positive association between inequality and growth. This result, however, depends on the assumption that holding capital is not risky. With risky investment we have two opposing effects: precautionary savings promote higher accumulation of capital but the risk in the use of capital discourages it. Thus, whether inequality promotes or discourages growth is ambiguous. See Angeletos, [2007]. In this section we review these theories and comment on their empirical plausibility.

4.2 Inequality affecting the business cycle

There is a well established tradition in macroeconomics that introduces financial market frictions in business cycle models. The key ingredients for introducing financial frictions is based on two assumptions: market incompleteness and heterogeneity. Although not often emphasized, inequality plays a central role in these models. For example, in the original contribution of Bernanke and Gertler, [1989], entrepreneurial net worth is central for the amplification of aggregate shocks. When more resources are in the hands of constrained producers (higher net worth), they can expand production and enhance macroeconomic activities. This can happen because they earn higher incomes or because their asset are worth more following asset price appreciations. Thus, these models posit a close connection between inequality and the business cycle. In this chapter we will also review the contributions that relate inequality to business cycle fluctuations.

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