Ebook Equity and Efficiency under Imperfect Credit Markets
Recent macroeconomic research has brought up credit market imperfections as a key channel through which inequality may affect aggregate output and growth. If borrowing is limited, marginal returns are not necessarily equalized across investment opportunities - which is costly to aggregate output if technologies are convex. Based on this reasoning it has been prominently argued in the literature that more inequality, i.e., shifting resources away from poorer individuals to richer ones, lowers output and the growth rate further since the differences in marginal returns become even larger.
In this paper, however, we show that the above intuition does in general not hold true once the credit market is not completely ”turned off” but only imperfect. Specifically, we show that even with a globally convex technology and limited borrowing an increase in inequality may actually boost aggregate output. At the heart of this result is the interest rate’s endogenous response to more inequality. With convex technologies, a regressive transfer from individuals belonging to the ”middle class” to the rich reduces the interest rate. A lower capital cost softens the borrowing constraints of all entrepreneurs but particularly those of the poorest agents. As a result, the poor may increase their investments substantially, and - since they face high returns - it may well be that this interest rate effect dominates the negative direct effect of more inequality in the middle or at the top end of the distribution.
We are, of course, not the only to point out that more inequality in presence of credit market imperfections may be good for output and growth. If the production function is not globally concave, the relationship between in equality and aggregate output is ambiguous as well (see, e.g., Galor and Zeira, 1993). However, we emphasize and illustrate by means of an example that the relationship may be non-monotonic even if non-convexities are entirely absent. Moreover, the example shows that a positive association between inequality (as measured, for instance, by the Gini index) and efficiency is not only a local phenomenon but may extend over a wide inequality-range. Hence, also with decreasing returns and significant borrowing constraints, the theory offers no clear prediction whether the Gini index should enter a growth regression with a positive or negative sign.
While the relationship between overall inequality and efficiency under imperfect credit is ambiguous in general, we find, however, that a specific type of inequality is clearly bad for efficiency. More inequality at the expense of the poorest part of the population (i.e., higher inequality at the bottom end of the distribution) unambiguously reduces aggregate output. Intuitively, the argument that the poor gain much better access to credit in response to regressive transfers does no longer go through in this case. The negative direct effect of a lower wealth endowment on the poor’s borrowing capacity dominates the interest rate effect. These results suggest that future empirical work on the transmission channels linking inequality to economic performance should use more specific measures of inequality. In particular, we conclude that the heterogeneous-returns argument should be evaluated by relating measures of relative poverty to subsequent economic growth.
The set-up of the present model follows Bénabou (1996) in assuming a decreasing-return-to-scale technology and by introducing heterogeneity with respect to initial capital endowments. However, unlike in Bénabou’s contribution, we assume an imperfect (rather than a completely closed) credit market. Borrowing is limited because credit contracts are not well enforced. Specifically, the sanctions against default by borrowers are imperfect.
The paper is organized as follows. Section 2 presents the model and characterizes the aggregate equilibrium. In Section 3, we derive the two main results and illustrate that the relationship between inequality and output may be non monotonic even in a simple example. Finally, Section 4 discusses the generality of our results and concludes.
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