Financial Frictions and Inequality

The objective of this subproject is twofold. In a first part, we plan to study the effects of the changes in the tightness of financial frictions in a general equilibrium heterogeneous agent model. We are interested in what fraction of the observed increase in the skill premium can be accounted for by the changes in financial conditions. To this end we will put particular emphasis on complementarities between skilled (college educated) workers and capital in production. The idea is that financial market liberalization - hence the relaxation of financial frictions – made it easier for owners of capital to expand their investment activities. In a model with complementarities between capital and skills this will drive up wages of skilled workers relative to wages of unskilled workers. Hence, two groups – the owners of capital and skilled workers - benefit from financial market liberalization, whereas the unskilled do not. The purpose then is to analyze the quantitative importance of this particular channel relative to others as a determinant of the observed trends in inequality.

In the second part, we will assess to what extent financial frictions contribute to changes in income inequality on the local level. To this end, we will start by empirically identifying how a specific shock to finance, i.e., a shock to financial intermediaries’ wholesale funding sources, changes income inequality at the urban level. Following this, we will explore whether the change in income inequality differs across industries and households. Specifically, we exploit the idea that because of technological reasons some industries rely more on bank financing than others, and explore whether income inequality increased more in industries that are more dependent on bank financing. Two separate working papers will be delivered that complement each other both in terms of methodologies and research questions.