Wealth Inequality and the Losses from Financial Frictions

Does wealth inequality exacerbate or alleviate the degree of misallocation in an economy where financial markets are imperfect? To address this question, I exploit the idea that inequality should have a different effect across sectors. Using a difference-in-difference strategy, I show that sectors that are more in need of external finance are relatively smaller in countries with higher income inequality. To rationalize this fact, I build a model in which sectors differ in their fixed cost requirement, agents face collateral constraints, and production is subject to decreasing returns. The model features key elements from the literature on financial frictions and economic development. I calibrate the model to match standard moments of the US economy. The calibrated model is consistent with the documented facts on inequality and cross-sector outcomes. At the calibrated parameters, wealth inequality exacerbates the effect of financial frictions on the economy. Quantitatively, an increase in wealth inequality that is consistent with an increase in income inequality of 15 points in Gini generates losses of 46 percent of per capita income.