Financial Policies and Income and Wealth Inequality: A Kuznetsian Story of Financial Deepening and Human Capital Accumulation

Type Thesis or Dissertation - Doctor of Philosophy
Title Financial Policies and Income and Wealth Inequality: A Kuznetsian Story of Financial Deepening and Human Capital Accumulation
Publication (Day/Month/Year) 2012
This dissertation examines whether and how financial policies affect the
distributions of income and wealth. It also explores and compares the evolution of
income inequality, along an inverted U-shaped Kuznetsian path, when only human
capital formation takes place and when the structural transformation of the labor force is
accompanied by financial development.
This is accomplished by numerically solving for the steady-state equilibrium of a
dynamic, stochastic, general equilibrium model of an economy with heterogeneous
households (subject to labor productivity shocks), heterogeneous firms (subject to
production shocks), and competitive banks that face frictions from policy-induced
repression, incomplete institutions, and market imperfections.
Policy simulations contrast the effects ─of direct interventions in financial
markets (namely, changes in required reserve ratios on deposits) and indirect
interventions that improve the market environment (namely, infrastructure and
institutions that differentially reduce default rates and costs of lending)─ on the wedge
between loan and deposit interest rates, deposits mobilized, credit available, output
levels, wage earnings and shares in the wage bill, wealth levels (household deposits), and
the dispersion of wage earnings and wealth (Gini coefficients).
Simulation results reveal that, while direct policy interventions (manipulating
required reserve ratios) may slightly improve income distributions, they do it at the cost
of substantially lowering financial deepening and output and wage levels. While these
adverse effects subside at advanced stages of development, these are not appropriate tools
to pursue distributional goals.
In contrast, pro-informal, pro-poor biased indirect policy interventions, resulting
in lower default rates from informal firms or lower costs of lending to informal firms,
show strong impacts in increasing output and wages (efficiency) and in reducing
inequality in the distributions of income and wealth (equity), especially at early stages of
economic development, when acute frictions in financial markets asymmetrically
penalize informal firms and low-skilled households.
At more advanced stages of development, the results are mixed. The distribution
of income may improve at the cost of lower levels of output and wealth accumulation
(when default rates decline) or inequality in the distribution of wealth may rise (when the
costs of lending decline).
When the original Kuznetsian story of a relationship between the structural
transformation of the labor force and inequality is augmented by financial development,
the Gini coefficient for the distribution of wage incomes is lower, at every stage of
human capital formation, the peak values of the coefficient are lower, and the distribution
of income starts to improve at an earlier stage in the development process.
The combined effect of human capital formation and financial development leads
to monotonic and larger reductions in the wedge between the interest rates charged on
loans and paid on deposits and to improved indicators of financial deepening, the volume
of deposits, and the GDP level.
The results for the augmented Kuznetsian scenario are confirmed when the model
parameters are calibrated with data for Pakistan. In this case, there is monotonically less
inequality in the distribution of wealth, along the Kuznetsian path, when financial
development accompanies human capital formation.

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