Does Financial Sector Development Increase Income Inequality? Some Econometric Evidence from Bangladesh

Topics: Economics, Economic growth, Gross domestic product Pages: 6 (1748 words) Published: January 28, 2013


Abu N.M. Wahid
Tennessee State University
Muhammad Shahbaz
COMSATS Institute of Information Technology, Lahore, Pakistan Mehmood Shah
University of Management and Technology, Lahore, Pakistan
Mohammad Salahuddin
Southeast University Banani, Dhaka, Bangladesh

This paper is an attempt to examine the relationship between financial development and income inequality. In doing so, we have used Bangladeshi data for the period 1985-2006. We have employed auto-regressive distributed lag (ARDL) methodology for cointegration. We have also carried out sensitivity analysis and stability tests. Our findings suggest that financial development increases income inequality. Economic growth seems to equalize income distribution. Inflation and trade openness also worsen income inequality. Finally, income inequality is being increased by social spending in the country over long run. This study provides new directions for policy makers to reduce income inequality to share the fruits of economic development among the wider spectrum of the society. Keywords: Financial sector, development, trade openness, income inequality, Bangladesh JEL Classifications: D14, D33, F1

Economic growth and its correlates have been the focus of a large number of studies over the recent past. These studies primarily put emphasis on various aspects or sources of growth. One of the important correlates of economic growth that has been studied prominently is the extent of financial sector development. The positive and robust relationship between well-functioning financial system and economic growth is empirically a well established fact. Higher levels of financial development are significantly and robustly correlated with current and future rates of economic growth, physical capital accumulation, and improvements in economic efficiency (see, Khan, 2000; Goldsmith, 1969; McKinnon, 1973; Roubini and Sala-i-Martin, 1992; King and Levine, 1993; Easterly, 1993; Pagano and Volpin, 2001; Beck, Levine and Loayza, 2000; Khan and Senhadji, 2000; Christopoulos and Tsionas, 2004; Iqbal, et al., 2006; Khan, Qayyum and Skiekh, 2005 and Shahbaz, 2009).

It is argued that capital market improvements benefit the rich more than the poor and hence contribute to increase income inequality. The main reason is that rich individuals have more potential than the poor ones to exploit new opportunities. It is also believed that the access of the poor to bank credits may be impeded because of the high cost involved therein, and, as such, financial development may be regressive for the poor, particularly at the initial stages of development (Greenwood and Jovanovic, 1990). The financial sector charges high set up cost against financial services during early periods of development to gain advantages from the screening and risk pooling. This cost is beyond the affordability of the poor people. As they are not in a position to use their savings for this outlay which pushes them further below in the income inequality trap (Clarke et al., 2003; Dollar and Kraay, 2003; Beck, Demirguc-Kunt and Levine, 2004). Financial market imperfections such as financial asymmetries, transaction costs, and contract enforcement costs may be especially binding for poor entrepreneurs who lack collateral, credit histories, and connections. These credit constraints will impede the flow of capital to poor individuals with high-return projects (Banerjee and Newman, 1993; Galor and Zeira, 1993), thereby reducing the efficiency of capital allocation and intensifying income distribution (Greenwood and Jovanovic, 1990; Banerjee and Newman, 1993 and, Aghion and Bolton, 1998).

The relationship between financial development and reductions in income inequality is not only a...
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