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The main goal of this paper is to describe an endogenous feedback mechanism through which imperfection in the credit market may amplify income inequality. When entrepreneurs are subject to a minimum investment requirement and entrepreneurs’ future revenue is not fully pledgeable for debt repayment, then the highest interest rate entrepreneurs can credibly offer to depositors depends not only on the marginal product of capital but also on entrepreneurs’ net wealth. This dependence creates an entrepreneurial rent which has both direct and indirect impacts on income inequality. On the one hand, entrepreneurial rent magnifies income inequality because it changes the balance between marginal product on capital (collected by entrepreneurs) and the interest rate (collected by depositors) and alters young agents saving decision. Entrepreneurial rent indirectly affects the labor income inequality because it distorts young agents’ labor supply decision and thus indirectly affects labor income earned by borrowers and lenders. Under some configuration of parameter values, the model predicts a Kuznets curve, i.e., an inverted-U relationship between per capita income and income inequality.
7 Summary and Conclusions
The two main goals of this paper are: (1) to present a mechanism through which credit market imperfection may magnify income inequality, and (2) to propose an alternative explanation of Kuznets’ inverted-U Hypothesis. I have shown that credit market imperfection along with minimum investment requirement creates an entrepreneurial rent which has both direct and indirect effects on income inequality. One major advantage of the model presented in this paper is its analytical tractability. However, some cautionary remarks should be pointed out about the predictions of the model. I do not argue that the credit market imperfection alone is responsible for increased income inequality, or that other sources of policy change, structural change, globalization, education policy, etc., are unimportant sources behind increased income inequality. Instead, I argue that credit market imperfection may also magnify income inequality.
At this point, I would like to point out some limitations of the model presented in this paper. First, the model has only one type of capital good and one type of final good. Second, the model does not allow for growth either in technology or labor force. Third, the economy is closed and thus does not interact with other economies. Due to these limitations, I can think of many ways in which the model can be extended. First, there is a shortage of theoretical and empirical research studying the impact of financial sector policies, such as bank regulations and securities law, on persistent inequality, and second, there is no conceptual framework developed in the literature which considers the joint and endogenous evolution of finance, inequality, and economic growth. The present paper represents a step towards research in this direction.