Financial Development, Cycles and Income Inequality in a Model with Good and Bad Projects

Financial innovation can promote economic growth by facilitating the efficient allocation of resources but can also provide the seeds for economic crises. Disparities in incomes between workers and entrepreneurs are enhaced during economic downturns.

Pub. Date
19 December, 2022
Pub. Type

Main points

  • Benefits and costs of financial development; Financial innovation can facilitate growth by allocating resources more efficiently; Financial innovation can hamper growth by allocating resources to unproductive activities; Endogenous business cycles; Income disparities along the cycle.

We introduce a banking sector and heterogeneous agents in the Matsuyama et al. (2016) dynamic over-lapping generations neoclassical model with good and bad projects. The model captures the benefits and costs of an advanced banking system which can facilitate economic development when allocates resources to productive activities but can also hamper progress when invests in projects that do not contribute to capital formation. When the economy achieves higher stages of development it becomes prone to cycles. We show how the disparity of incomes across agents depends on changes in both the prices of the factors of production and the reallocation of agents across occupations.

Related discussion papers:
"Banking Concentration and Financial Crises" (DP 516)
"Micro level data for macro models: the distributional effects of monetary policy" (DP 529)