Intermediate Macroeconomics Questions, due on April 29, 3:00pm (UTC+8)

Wealth and Intergenerational Inequality

Part II

1. Introduction.

a) Overview

In the first part of this lecture, we have discussed the causal relationship.

Asset inequality in the current period => Income inequality in the current period => Asset inequality in the following period

Under the assumption that individuals live for one period, this causal relationship becomes intergenerational.

In the first part of this lecture, we demonstrated that asset holdings influence one’s occupational choice as only those with large enough asset holdings could become entrepreneurs.

In addition, we showed that the occupational distribution and the degree of income inequality depends on whether there is a critical mass (large enough share) of individuals who hold at least a threshold level of asset holdings to obtain a loan and become entrepreneurs.

In the second part of this lecture, we will emphasize that the resulting income inequality from the initial asset distribution could affect savings behaviour and, in turn, influence the amount of extra assets or debt parents leave to their offspring.

b) Consumption inequality vs. income inequality

· Relationship between consumption and income

As you may recall from the Solow growth model with no transaction costs, individuals could either consume, , or save/invest, , their income, .

Consumption inequality differs from income inequality only with respect to the unit of analysis, consumption vs. income.

· Relationship between consumption inequality and income inequality

Figure 1 indicates that consumption inequality (Gini coefficient = 0.25 in 1997) is considerably lower than (before-tax) income inequality (Gini coefficient = 0.39 in 1997).

This discrepancy between the two types of inequality could be driven by:

· saving and borrowing,

· redistributive government programs funded through taxation.

Figure 1

Source: IRPP (2016)

Figure 2 provides a comparison between before-tax (or market) income inequality and after-tax income inequality (Gini coefficient = 0.30 in 1997).

This decomposition allows us to compare after-tax income inequality (Gini coefficient = 0.30 in 1997) to consumption inequality (Gini coefficient = 0.25 in 1997).

Figure 2

Source: IRPP (2016)

· Implications of discrepancies between consumption inequality and after-tax income inequality

The lower Gini coefficient for consumption inequality relative to the Gini after-tax income inequality suggests that:

· low-income individuals on average borrow,

· high-income individuals on average save.

Why? Low-income individuals must have higher consumption relative to their income and high-income individuals must have lower consumption relative to their income.

2. Economic impact of asset/debt accumulation on intergenerational inequality.

a) Asset accumulation vs. debt accumulation

Whether credit constrained individuals save towards their assets or borrow from their assets has major implications on the share of credit constrained individuals in future generations.

The savings of the credit constrained individuals are added to their assets, which are inherited in the following period by their offspring. If this process is sustained over multiple generations, the assets of some future generation become sufficiently large, and these individuals are no longer credit constrained.

If non-credit constrained individuals dissave, i.e., their consumption exceeds income, the reverse process could take place over multiple generations.

b) Asset/debt accumulation and access to credit

We will demonstrate through a numerical example how asset accumulation could affect the occupation distribution and labour market outcomes several generations down the road by inducing a switch from the low-wage equilibrium to the high-wage equilibrium.

Numerical example:

Suppose that . Suppose that 70 % of the population have asset holdings and the remaining 30 % of the population .

In addition, suppose that each individual saves 30 % of their income.

Period 1:

Savings:

Period 2:

Savings:

Period 3:

Savings:

Period 4:

Thew assets become , which exceeds the threshold requirement .

c) Key insights and empirical evidence

· Theoretical predictions

It takes several generations for an economy to go from the low-wage equilibrium to the high-wage equilibrium or vice versa.

We will present evidence that asset accumulation from low-income individuals is not something we observe in the data. To the contrary, most low-income individuals borrow and accumulate debt.

· Empirical evidence

Figure 3 indicates that the debt-to-income ratio decreases from the lowest income quintile to the highest income quintile for the Greater Toronto Area (GTA) and Metro Vancouver.

When interpreting the results in Figure 3, we also need to note that is more common households in the upper income quintiles to have collateralized debt, e.g., mortgages, while the households in the lower income quintiles to have non-collateralized debt, e.g., credit card debt.

Figure 3

Source: Statistics Canada (2016)

This conjecture is supported by the evidence provided in Figure 4 for the GTA and Metro Vancouver: higher home ownership rates of a semi-detached house are indeed reported for the highest income quintile relative to the lowest income quintile.

Figure 4

Source: Statistics Canada (2019)

Figure 5 reveals that the assets (of owning a home) exceeds the amount of the debt by several factors to 1.

Putting all the evidence together, we may conclude that indeed:

· Low-income households on average accumulate larger debt,

· High-income households on average increase their asset holdings.

Figure 5

Source: Statistics Canada (2019)

· Policy responses

Why does the issue of switching from one equilibrium to another not receive a response from the public or policy makers?

Asset inequality per se does not affect the nature of the labour market equilibrium unless the economy is in proximity to the critical mass of credit constrained individuals. For instance, the asset accumulation from period 3 to period 4 in the numerical example.

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