Nonlinear impact of financial deepening on income inequality

Abstract

This paper looks at the influence of financial deepening (private bank credit) on income inequality in developed economies. Building on a model of financially open economies (Kunieda et al. (Macroecon Dyn 18:1091-1128, 2014)), defining its endogenous economic growth rate, and extending its implications also for top income shares, it is shown that the impact of bank credit on inequality depends on the gap between the real interest rate and the GDP growth rate ('r − g'). This finding is robustly confirmed by the empirical analysis on a few samples of OECD and EU countries, both for the Gini index and for top income shares. Both the econometric evidence and simple evidence show that the presence of this type of non-linearity (an interaction between financial deepening and r − g) is likely to be one of the reasons for the mixed results that may be found in the empirical literature on the relationship between the financial deepening and income inequality. Keywords Credit • Financial deepening • Income inequality • Interest rates • Open economy • r − g JEL Classification E44 • F43 • P43 V. Kvedaras: We thank the reviewers for useful comments with the usual disclaimer. The opinions expressed are those of the authors only and should not be considered as representative of the European Commission's official position.

Rethinking the Income Inequality and Financial Development Nexus. A Study of Nine OECD Countries

“…These findings are similar to other studies carried out in Europe [50,51] and the U. S. [35,37,75] and confirm the prediction that, in financially open economies, financial deepening could lead to increasing inequality measured by the Gini index [17]. The same conclusion is reached for few samples of OECD and EU countries [17] where excessive levels of indebtedness and financialization [41,42], a common pattern in advanced countries, appears to be the factors behind the rise in income inequality.…”

“…However, in tune with the "too much finance hypothesis" (U-shaped pattern), some studies have found that although in the early stages of financial development, the role played by the financial system is positive and contributes to narrowing the income-inequality gap, there is a threshold beyond which further financial deepening will lead to a reverse effect, and inequality will start to rise [20,46,47]. Recent studies on OECD and EU countries have shown that the impact of bank credit on inequality could depend on the gap between the real interest rate and the GDP growth rate [17].…”

“…We chose the group of G7 countries (Canada, France, Germany, Italy, Japan, the U.K., the U.S.) and two southern Europe economies (Spain and Portugal) as exponents of advanced countries that during the financial crises received financial help from the EU. Indeed, by focusing solely on advanced countries we would be better able to identify specific patterns related to the "financialization process" of these countries, and identify the main drivers of income inequality, which in a mixed sample of countries would be different [17].…”

“…On these grounds, the debate about the impact of financial systems on economic growth and sustainable development has been reopened to analyze if there is a degree of financial depth beyond which there are no more positive benefits in terms of growth and investment, but still significant costs in terms of inequality, financial fragility, and sustainability. Recent studies find that financial development contributes to lower inequality up to a point [15,16], but as financial development proceeds further, it contributes to higher inequality [17]. Other studies empirically investigate the effects of financial development on incomes within various income groups in the same country and demonstrates a positive but non-linear effect indicating that promoting a balanced financial development would help to ease the income gap between country residents [18].…”

The Impact of Financial Deepening on Economic Growth: Empirical Evidence from Yemen (1994-2018)

“…They suggest that a lack of control over structural discontinuities may lead to erroneous conclusions about reducing income inequality in Nigeria. Benczúr, P., & Kvedaras, V. [22] private bank credit expansion and income inequality in developed economies are studied. Mixed results found in the empirical literature on the relationship between financial deepening and income inequality are likely to be non-linearity (an interaction between financial deepening and rgrg).…”