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Income inequality, consumer debt, and prudential regulation: An agent-based approach to study the emergence of crises and financial instability

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  • D'Orazio, Paola

Abstract

The paper presents an agent-based model to study the interaction between income inequality and prudential regulations in a macroeconomic framework characterized by consumer debt. Simulation results show that income inequality is detrimental to both macro and financial stability as it leads to higher credit demands, higher unemployment rates, economic volatility, and financial fragility. Besides the importance of consumers' leveraging, deleveraging externalities are found to be equally important for the emergence of crises and financial fragility because of the liquidity risk they entail. Minsky moments are also observed; they are related to consumers' prudential behavior and their beliefs about the macroeconomic conditions. Concerning the policy relevance of our investigation, simulations allow us to highlight that the effectiveness of prudential regulation depends on the phase of the business cycle and that there is not a “one-size-fits-all” regulation. This study emphasizes that regulatory constraints should take into account the features of the economic agents, such as the distribution of income and their willingness to borrow, in addition to the features of the financial sector.

Suggested Citation

  • D'Orazio, Paola, 2019. "Income inequality, consumer debt, and prudential regulation: An agent-based approach to study the emergence of crises and financial instability," Economic Modelling, Elsevier, vol. 82(C), pages 308-331.
  • Handle: RePEc:eee:ecmode:v:82:y:2019:i:c:p:308-331
    DOI: 10.1016/j.econmod.2019.01.015
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    Keywords

    Agent-based modeling; Banking regulation; Household debt; Financial fragility; Income inequality; Minsky moments;

    JEL classification:

    • D14 - Microeconomics - - Household Behavior - - - Household Saving; Personal Finance
    • D31 - Microeconomics - - Distribution - - - Personal Income and Wealth Distribution
    • E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • G01 - Financial Economics - - General - - - Financial Crises

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