This dissertation examines whether and how financial policies affect the distributions of income and wealth. It also explores and compares the evolution of income inequality, along an inverted U-shaped Kuznetsian path, when only human capital formation takes place and when the structural transformation of the labor force is accompanied by financial development.
This is accomplished by numerically solving for the steady-state equilibrium of a dynamic, stochastic, general equilibrium model of an economy with heterogeneous households (subject to labor productivity shocks), heterogeneous firms (subject to production shocks), and competitive banks that face frictions from policy-induced repression, incomplete institutions, and market imperfections.
Policy simulations contrast the effects -of direct interventions in financial markets (namely, changes in required reserve ratios on deposits) and indirect interventions that improve the market environment (namely, infrastructure and institutions that differentially reduce default rates and costs of lending)- on the wedge between loan and deposit interest rates, deposits mobilized, credit available, output levels, wage earnings and shares in the wage bill, wealth levels (household deposits), and the dispersion of wage earnings and wealth (Gini coefficients).
Simulation results reveal that, while direct policy interventions (manipulating required reserve ratios) may slightly improve income distributions, they do it at the cost of substantially lowering financial deepening and output and wage levels. While these adverse effects subside at advanced stages of development, these are not appropriate tools to pursue distributional goals.
In contrast, pro-informal, pro-poor biased indirect policy interventions, resulting in lower default rates from informal firms or lower costs of lending to informal firms, show strong impacts in increasing output and wages (efficiency) and in reducing inequality in the distributions of income and wealth (equity), especially at early stages of economic development, when acute frictions in financial markets asymmetrically penalize informal firms and low-skilled households.
At more advanced stages of development, the results are mixed. The distribution of income may improve at the cost of lower levels of output and wealth accumulation (when default rates decline) or inequality in the distribution of wealth may rise (when the costs of lending decline).
When the original Kuznetsian story of a relationship between the structural transformation of the labor force and inequality is augmented by financial development, the Gini coefficient for the distribution of wage incomes is lower, at every stage of human capital formation, the peak values of the coefficient are lower, and the distribution of income starts to improve at an earlier stage in the development process.
The combined effect of human capital formation and financial development leads to monotonic and larger reductions in the wedge between the interest rates charged on loans and paid on deposits and to improved indicators of financial deepening, the volume of deposits, and the GDP level.
The results for the augmented Kuznetsian scenario are confirmed when the model parameters are calibrated with data for Pakistan. In this case, there is monotonically less inequality in the distribution of wealth, along the Kuznetsian path, when financial development accompanies human capital formation.