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Endogenous Growth, the Distribution of Wealth, and Optimal Policy under Incomplete Markets and Idiosyncratic Risk

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  • Christiane Clemens
  • Maik Heinemann

Abstract

This paper combines the standard incomplete markets model of uninsurable idiosyncratic risks and borrowing constraints with the Arrow/Romer approach to endogenous growth to analyze the interaction of risk, growth, and inequality, the latter also endogenously determined in equilibrium. We derive conditions on existence and nonexistence of balanced growth paths. Major results include that growth, inequality, and risk are positively related in our model, but we also identify a hump–shaped relationship between welfare and risk, indicating a tradeoff relationship between risk–pooling and growth in the determination of welfare. We employ the prototypical policy implications of the underlying growth model (i.e. subsidizing capital returns) and find that the tax–transfer scheme positively affects growth while simultaneously reducing wealth inequality in the economy. The benefits and burdens of the underlying policy are unequally distributed, which raises the issue of politico–economic equilibria. We provide results on majority voting, finding that that the median voter prefers less than optimal subsidies on investment. Interestingly, the society might even vote against a policy providing full insurance against idiosyncratic risk, because welfare losses of lower growth more than offset welfare gains from lower risk

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Bibliographic Info

Paper provided by DEGIT, Dynamics, Economic Growth, and International Trade in its series DEGIT Conference Papers with number c017_054.

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Length: 30 pages
Date of creation: Sep 2012
Date of revision:
Handle: RePEc:deg:conpap:c017_054

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Keywords: endogenous growth; wealth distribution; idiosyncratic risk; borrowing constraints; heterogeneous agents; optimal policy;

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References

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  1. Fatih Guvenen, 2005. "An Empirical Investigation of Labor Income Processes," Macroeconomics 0508026, EconWPA.
  2. Jappelli, Tullio & Pagano, Marco, 1992. "Saving, Growth and Liquidity Constraints," CEPR Discussion Papers 662, C.E.P.R. Discussion Papers.
  3. Kopecky, Karen A. & Suen, Richard M. H., 2009. "Finite State Markov-Chain Approximations to Highly Persistent Processes," MPRA Paper 15122, University Library of Munich, Germany.
  4. S. Rao Aiyagari, 1993. "Uninsured idiosyncratic risk and aggregate saving," Working Papers 502, Federal Reserve Bank of Minneapolis.
  5. S. Rao Aiyagari & Ellen R. McGrattan, 1997. "The optimum quantity of debt," Staff Report 203, Federal Reserve Bank of Minneapolis.
  6. Bertola, Giuseppe, 1991. "Factor Shares and Savings In Endogenous Growth," CEPR Discussion Papers 576, C.E.P.R. Discussion Papers.
  7. Huggett, Mark, 1993. "The risk-free rate in heterogeneous-agent incomplete-insurance economies," Journal of Economic Dynamics and Control, Elsevier, vol. 17(5-6), pages 953-969.
  8. Galor, Oded & Zeira, Joseph, 1988. "Income Distribution and Macroeconomics," MPRA Paper 51644, University Library of Munich, Germany, revised 01 Sep 1989.
  9. Kristin J. Forbes, 2000. "A Reassessment of the Relationship between Inequality and Growth," American Economic Review, American Economic Association, vol. 90(4), pages 869-887, September.
  10. Persson, T. & Tabellini, G., 1993. "Is Inequality Harmful for Growth," Papers 537, Stockholm - International Economic Studies.
  11. Banerjee, Abhijit V & Newman, Andrew F, 1993. "Occupational Choice and the Process of Development," Journal of Political Economy, University of Chicago Press, vol. 101(2), pages 274-98, April.
  12. Deininger, Klaus & Squire, Lyn, 1998. "New ways of looking at old issues: inequality and growth," Journal of Development Economics, Elsevier, vol. 57(2), pages 259-287.
  13. Kjetil Storesletten & Chris I. Telmer & Amir Yaron, 2004. "Cyclical Dynamics in Idiosyncratic Labor Market Risk," Journal of Political Economy, University of Chicago Press, vol. 112(3), pages 695-717, June.
  14. Perotti, Roberto, 1994. "Income distribution and investment," European Economic Review, Elsevier, vol. 38(3-4), pages 827-835, April.
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