International financial integration and income inequality in a stochastically growing economy

We employ a stochastic growth model to study the impact of international financial globalization on income inequality. A key element is that financial frictions facing the economy pertain to both lending and borrowing abroad, and the process of financial liberalization is specified in terms of reducing these frictions. We emphasize two key channels through which liberalization affects inequality. The first is by reducing the costs of investing and borrowing abroad. Since these activities favor the wealthy, they tend to increase inequality. But, in addition, these two forms of liberalization have sharply contrasting effects on domestic activity causing contrasting impacts on inequality. Numerical simulations suggest that income inequality is more sensitive to financial liberalization that favors foreign investment than if it is directed to reducing foreign borrowing costs. The simulations also suggest that the overall liberalization that occurred during 1970–2015, accounted for a significant fraction of the increase in income inequality experienced over that period. The main findings are broadly supported by the empirical evidence using the most recent data for a sample of 96 countries for the period 1970–2015.