Dynamic Status Effects, Savings, and Income Inequality

This paper advances the hypothesis that the intensity of status preferences depends negatively on the average wealth of society (endogenous dynamic status effect), in accordance with empirical evidence. Our behavioral driven theory is able to replicate the contradictory historical facts of an increasing saving rate along with declining returns on capital over time. As an implication of our hypothesis, we are able to provide a theoretical foundation for the observed dynamics on comparative development of income inequality across different countries. In particular, our theory implies that, as an economy develops, the saving rate increases during transition altering the speed of convergence relative to the standard neoclassical growth model. The initially lower and then increasing saving rate during the process of development benefits the wealthy households relative to poor ones, as the rate of interest on capital declines at a lower rate. Therefore, the endogenous dynamic status effect contributes to a rise in wealth inequality. Along the same lines, we analyze the behavior of inequality in response to changes in wealth (income) induced by productivity shocks. Under a positive productivity shock, in economies with a strong enough endogenous dynamic status effect, inequality increases - a fact that we experience in many countries around the globe.