Section A continued…

d.) Policy makers realise that, under the institutional arrangements they find
themselves in, fiscal policy can only be implemented with a two period lag
and decide to explore alternative monetary policy interventions. Which
would you advise and why?

As we see from the answers provided for the previous questions, an effective
lower bound renders conventional monetary policy (adjusting nominal interest
rates) insufficient to offset the adverse demand shock. As a result, the economy
continues to experience output gaps and non-equilibrium inflation.

Looking beyond, I would seriously consider pursuing unconventional monetary

policy such as quantitative easing (QE) that is unrestrained by effective lower
bounds. To be more specific – going beyond short-term rates, reserve ratios and
targeting the private agents (financial institutions) and private sector assets
(typically owned by financial institutions) instead. In times of easing, purchasing
private sector assets would inject liquidity in the economy and encourage
financial institutions to lend money. I believe that money neutrality does not
hold, at least in the short-run, and therefore believe that QE will have a real
effect in the economy beyond affecting price levels.

Furthermore, under conditions where the zero lower bounds are binding, we
may see that spreads between the intended benchmark rate and specific market
rates may begin to diverge due to liquidity premiums instead of, and in addition
to, risk premiums. When this occurs, the relationship between short-term rates
and effective rates become impaired. In such a scenario, I would encourage the
monetary authority to engage in credit easing (purchase of commercial paper,
bonds, and asset backed securities) to mitigate widening spreads.

e.) Under the assumption over the lag in fiscal policy in (d), would you still
recommend the use of government spending to escape the liquidity trap?
Briefly justify your answer.

No, I would not recommend using government spending to escape the liquidity
trap. A two period lag in enacting fiscal policy means that any fiscal policy
decided upon on period one will only come into effect in period three. Given
that agents know that the shock will last only two periods and that the economy

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will return to equilibrium in the third period, fiscal policy will only come into
effect when the economy has already returned to equilibrium. In short, fiscal
policy will be pro-cyclical and useless in escaping the liquidity trap.

Section B
The development of endogenous growth theories in the 1980s put the
discussion of income and redistribution back on the research agenda.
Several authors in the 1990s promoted the argument that inequality is bad
for economic growth.

a.) Outline the economic mechanisms suggested by this literature through

which inequality adversely affects growth.

It can be found in existing literature that a distinction has been made between
the economic and political channels in which income inequality supposedly
affects growth. The prominent economic mechanisms through which inequality
affects growth include: 1) fertility rates, 2) imperfect capital markets, and 3)
domestic demand.

Inequality is believed to adversely affect growth through a fertility / human

capital channel. Parents face a tradeoff between the quantity and quality of their
descendants. An increase in human capital has two effects on fertility. The
income effect implies the ability to raise more children and hence higher fertility
rates, on the other hand higher human capital raises the opportunity cost of
raising children and there is substitution effect that results lower fertility rates. At
higher levels of human capital, the substitution effect is believed to prevail. That
said, assuming that increased income equality (i.e. human capital of poor
increases) does indeed result in a decline in fertility and therefore higher
investment in human capital, then this higher investment in human capital would
also lead to higher economic growth.

Galor and Zeira (1993) proposed that provided imperfect capital markets and
borrowing constraints, initial distributions of wealth have direct implications on
patterns of investment and therefore growth in an economy. The ‘investment’ in
question here is investment by agents into human capital, also known as

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education. Consider the fact that there are significant fixed costs associated with
acquiring education. If agents are unable to borrow against future earnings then
it is apparent that a dynasty that starts out as poor will to be unable to invest in
human capital and will keep doing so for generations. It therefore follows that
when there is more inequality, less people are able to make the necessary
investments to develop human capital and hence economic growth is
hampered.

Murphy et al (1989) believed that central to economic growth was the

composition of domestic demand. For industrial markets to expand, the ideal
composition of demand would concentrate buying power in the hands of
consumers of manufactured goods. Since the middle class is the ideal and
realistic consumer class of manufactured goods, it is immediately apparent that
having a large, vibrant, concentrated middle class population bodes well for
economic growth. On the other hand if there was large income inequality – that
is, if wealth and buying power was concentrated among the very rich – domestic
demand will find itself predominantly composed of handmade and imported
luxuries instead of manufactured goods, limiting economic growth.

b.) Outline the political channels suggested by this literature through which
inequality adversely affects growth.

Alesina & Perotti’s (1994) paper provides a concise and insightful summary on
the proposed theories in which income inequality adversely affects economic
growth through political channels. The two main political channels in focus were:
1) the fiscal channel, and 2) the instability channel.

In the fiscal channel, it was proposed that income inequality had a determining
influence on the level of government taxation and expenditure through the
voting process. Through this mechanism, it is implied that unequal societies (i.e.
societies with relatively more poor agents) prefer, and are more likely, to enact
high taxation regimes, discouraging investment and hence hampering economic
growth. In a more detailed breakdown, Alesina & Perotti also highlight other
similar papers that elaborate on the fiscal channel (Alesina and Rodrik (1994),
Bertola (1993), and Persson and Tabellini (1991)). All papers analogously suggest
that when there is rising government expenditure as a share of GDP (as a result
of the voting process) and, correspondingly, there is an accompanying rise in

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taxation, after-tax marginal product of capital decreases for private investors,
resulting in lower accumulation of capital, and lower growth.

The instability channel directly refers to inequality’s effect on social unrest.

Simply put, unequal societies that have a large number of poor agents facing a
small group of wealthy elites are more likely to experience social unrest fueled
by dissatisfaction with the existing socio-economic conditions. As a result,
radical changes are demanded by the poor, followed by often violent and illegal
seizures of power. As shown by Alesina and others (1992), there appears to be
empirical evidence that political instability (interpreted as government changes)
adversely affects economic growth. After all, political instability results in
business uncertainty, reducing the incentive to invest, thereby reducing growth.
Through this mechanism, poor countries may find themselves trapped in a
vicious circle where instability arises when growth is deficient, and growth is
unattainable because they are unstable.

Lastly, Keefer and Knack (2002) suggest that income inequality, which is
interpreted to be a proxy for social-polarization, adversely affects economic
growth. Inequality makes collective decision-making (especially for much
needed economic reforms) difficult. This stems from the fact that inequality
creates ‘factions’ within the political landscape, each with differing standpoints
on policy. Radical polarization is expected to rise with inequality and increasing
polarization, in turn, reduces the stability of government policies that become
increasingly susceptible to deviation and changes over time. Keefer and Knack
empirically found that large changes in policies do indeed have negative
implications on the security and predictability of property and contractual rights.
This resulting uncertainty in the security of property and contractual rights
reduces the incentive to invest, do business, and take on risky projects, and as a
result economic growth is sacrificed.

c.) Contrast the main arguments of this literature with early discussions on
the relationship between inequality and growth (i.e. Smithian trade-off and
Kuznets curve).

Despite the emergence of some consensus amongst literature discussed in the

previous questions that inequality adversely affects growth, this assertion

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remains challenged by earlier discussions such as the Smithian trade-off and the
Kuznets curve.

Apparent by the name, the Smithian trade-off, a classical theory, suggests, that a
trade-off between growth and inequality is inevitable. Growth is fueled by
capital accumulation, which in turn depends on investment (savings) that
predominantly comes from the reinvestment of profits by businesses. Therefore,
the higher the share of profits of total income, the higher the rate of investment
and growth. Provided that profits accrue mostly to high-income groups (capital-
owners), and shall continue to accrue exclusively to high-income groups, it
becomes clear that higher inequality in this case benefits economic growth
through creating more investment. That said, if saving (investment) was
overtaxed and redistributed to mitigate income inequality, one would assert
(based on empirical correlation Lindert & Williamson (1985)) that as investment
surplus is hampered by redistributive policies, investment decreases and
correspondingly inequality decreases at the expense of economic growth.

The Kuznets curve is a graph that illustrates the relationship between income
inequality and income per capita. Kuznets proposed that as an economy
develops, income inequality first increases then decreases. This relationship is
illustrated by an inverted U-shape. Kuznets hypothesized that in the early days of
economic development, investment opportunities are abundant for those with
the capital to invest but not for the poor, hence the rich continued to get richer.
Exacerbating the widening income gap was urbanization. As an economy
urbanizes / industrializes, the influx of workers into cities keeps wages low.
However, over time, the process of industrialization is expected to decrease
income inequality through increases in overall wages.

In contrast to the earlier literature, the Smithian trade-off and the Kuznets curve
together suggest that higher inequality, a natural byproduct of economic growth
according to the Kuznets hypothesis, can in fact accelerate economic growth
(Smithian argument). In other words, the poor may be made worse off today due
to higher inequality but they may collectively escape poverty more rapidly.
These theories encourage societies to preserve any inequality due to its positive
effects on growth and propose that enacting measures to mitigate inequality
using redistributive measures would only risk hampering growth.

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Furthermore, one could point out that the Smithian trade-off and the Kuznets
curve share a simple, common difference with the more recent literature
discussed in the previous questions. The difference is that newer literature
based their arguments on the belief that inequality determines economic
growth, regardless of whether it were through a political or economic channel,
whereas earlier discussions (Smithian, Kuznets) interpreted inequality as a
consequence of economic growth. Take for example the fiscal and instability
channels mentioned above. Inequality was assumed to have power in
determining policy through the voting process, which ultimately determined the
fate of economic growth. As for the economic channels, varying degrees
inequality was simply taken, as given, to have implications on investment,
fertility rates, and domestic demand. It was as if degrees of inequality were an
endowment rather than a byproduct of decades and centuries of economic
processes.

Ultimately, this is a debate that goes well beyond the scope of a short answer,
and has, alongside it, an extensive history of debate and conflicting arguments.

d.) In more recent times, some authors have argued that inequality is good
for growth (e.g. Li and Zhou, 1998; Forbes, 2000). Is this argument different
from the Smithian trade-off hypotheses? Explain.

Recent works, which suggest that inequality is good for growth, have the same
conclusion put forth by the Smithian trade-off. Despite the final conclusion being
the same, however, the proposed mechanisms in which inequality results in
higher growth differ significantly. In some sense, recent works can be
interpreted to simply be empirical re-evaluations of the earlier works discussed
in questions one and two using alternative, more advanced techniques.

For example, like Alesina and Rodrik (1994), Forbes suggested that inequality
affects growth via a political channel, where public voting and hence income
inequality determined government taxation and spending policy. But unlike his
earlier counterparts, he showed theoretically, that inequality could have positive
effects on growth. Correspondingly, Forbes also showed through empirical
(baseline testing and sensitivity analysis) that income inequality was positively
associated with growth. Similarly Li and Zhou (1998) challenged earlier assertions

11
that income inequality is bad for growth by utilizing improved datasets and
modern (panel) econometric techniques and found conclusive results.

Recent works clearly differ in their approach with the Smithian trade-off to arrive
at a similar conclusion. Furthermore, since the recent works are somewhat re-
evaluations of the works of the 90’s and late 80’s their arguments remain based
on the claim that inequality determines economic growth rather inequality being
a consequence of economic growth.

e.) Could you think of any reason why social scientists have such a hard time
explaining the relationship between inequality and growth? Explain.

Inherent in the exploration of the relationship between inequality and growth

are three main issues why finding conclusive results may be so challenging: 1)
the chicken or egg problem, did inequality or growth come first? 2) isolating the
different channels in which inequality influences growth and addressing the
impact of institutions, 3) what type of inequality should we measure?

Which came first, which one causes which, inequality or growth? Similarly, this
can be interpreted as an endogeneity problem. Apparent by the differing
approaches between the Smithian trade-off and the Kuznets curve, and later
works, the answer is not straightforward. It may simply be a fact that inequality
and growth are inevitably endogenous and interrelated, and that any changes in
inequality may negatively or positively affect growth, which may again negatively
or positively affect inequality. Isolating the effects in such a confounding
interrelated system would be impossible. From an empirical standpoint, one
solution may be to attempt to determine and investigate the starting conditions
of the societies / economies in question. Knowing these starting conditions
(levels of inequality) and the economic processes that succeeded those
conditions may help answer some questions. However, data limitations come
into play here.

Another obstacle to determining the exact relationship between inequality and

growth is deducing which of many channels in which they are related are truly
relevant. As evident by the discussions above, there is a multitude of existing
literature with different assertions and different conclusions on how inequality
and growth is related. Furthermore we have not discussed the effect of
inequality on institutions (or the opposite). It is very important to control for

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institutions, which, upon establishment, ultimately shape the socio-political
arena in which any further economic processes are to take place. That said, in
order to better understand the relationship between inequality and growth, it
may be better to focus the relationship between inequality and institutions
instead.

Lastly, issues and debates arise in determining the type of inequality we should
investigate (i.e. land, income, human capital). Even if all types of inequalities are
relevant, it again becomes a challenge to determine which one is most
important. This has particularly relevant implications on designing policy to spur
economic growth.

References

▸ ***Alesina & Perotti (1994). “The Political Economy of Growth: A Critical Survey of the
Recent Literature.” World Bank Economic Review 8:351-71

▸ **Alesina & Rodrik (1994). "Distributive Politics and Economic Growth." Quarterly
Journal of Economics 109(May):465-90.

▸ *Forbes, K. (2000) “A Reassessment of the Relationship between Inequality and Growth”.

American Economic Review, 90(4):869-87

▸ *Galor & Zeira (1993) “Income Distribution and Macroeconomics”. Review of Economic
Studies, 60(1):35-52

▸ **Keefer & Knack (2002) “Polarization, Politics and Property Rights: Link between
Inequality and Growth”, Public Choice 111:127-54

▸ *Kuznets, S. (1955) “Economic Growth and Income Inequality”. American Economic

Review.

▸ **Lindert, P. & J. Williamson (1985) “Growth, Equality, and History” Explorations in

Economic History 22, 341-377

**Li, H. & H. Zou, (1998). "Income Inequality Is Not Harmful for Growth: Theory and
Evidence,” CEMA Working Papers 74, China Economics and Management Academy, Central
University of Finance and Economics.

*Bertola, G. (1993) “Market Structure and Income Distribution in Endogenous Growth

Models”, American Economic Review 83:1184-99

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