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

  • Christiane Clemens
  • Maik Heinemann

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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Paper provided by CESifo Group Munich in its series CESifo Working Paper Series with number 3832.

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Date of creation: 2012
Date of revision:
Handle: RePEc:ces:ceswps:_3832
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  1. Jappelli, Tullio & Pagano, Marco, 1994. "Saving, Growth, and Liquidity Constraints," The Quarterly Journal of Economics, MIT Press, vol. 109(1), pages 83-109, February.
  2. S. Rao Aiyagari & Ellen R. McGrattan, 1997. "The optimum quantity of debt," Staff Report 203, Federal Reserve Bank of Minneapolis.
  3. Persson, Torsten & Tabellini, Guido, 1994. "Is Inequality Harmful for Growth?," American Economic Review, American Economic Association, vol. 84(3), pages 600-621, June.
  4. Karen A. Kopecky & Richard M. H. Suen, 2009. "Finite State Markov-Chain Approximations to Highly Persistent Processes," Working Papers 200904, University of California at Riverside, Department of Economics, revised May 2009.
  5. 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.
  6. Fatih Guvenen, 2009. "An Empirical Investigation of Labor Income Processes," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 12(1), pages 58-79, January.
  7. 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.
  8. Bertola, Giuseppe, 1991. "Factor Shares and Savings In Endogenous Growth," CEPR Discussion Papers 576, C.E.P.R. Discussion Papers.
  9. Abhijit V. Banerjee & Andrew F. Newman, 1990. "Occupational Choice and the Process of Development," Discussion Papers 911, Northwestern University, Center for Mathematical Studies in Economics and Management Science.
  10. Oded Galor & Joseph Zeira, 2013. "Income Distribution and Macroeconomics," Working Papers 2013-12, Brown University, Department of Economics.
  11. 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.
  12. Perotti, Roberto, 1994. "Income distribution and investment," European Economic Review, Elsevier, vol. 38(3-4), pages 827-835, April.
  13. S. Rao Aiyagari, 1993. "Uninsured idiosyncratic risk and aggregate saving," Working Papers 502, Federal Reserve Bank of Minneapolis.
  14. 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.
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