Credit Expansion and Inequality: When Does it Help and When Does it Hurt?

This paper investigates the heterogeneous effects of credit expansion on income inequality by focusing on the efficiency of financial intermediation, captured by a productivity parameter in the theoretical model and proxied by overhead cost in the empirical analysis. Building on a general equilibrium model with an explicit banking sector, the study proposes that the inequality-reducing effects of credit expansion depend critically on how efficiently banks transform deposits into loans. Using a panel dataset covering 139 countries (75 high- and upper-middle-income and 64 low- and lower-middle-income) between 2000 and 2019, the empirical strategy explores whether the impact of financial development, measured as the ratio of bank credit to deposits, varies by banking system effectiveness, proxied by low overhead cost. Fixed-effects and two-stage least squares estimates for high- and upper-middle-income countries reveal that credit expansion reduces inequality only when overhead costs are low. The results for the full sample and low- and lower-middle-income countries are statistically insignificant, with the latter group showing a reversed and imprecise relationship. The findings support the hypothesis that financial development alone cannot improve distributional outcomes. Instead, it must be supported by efficient intermediation to ensure broader access to credit and reduce inequality.