Income Inequality, Economic Growth and Its Effects .

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Income Inequality, Economic growth and its effects .

Abstract

“Some people are of the view that income inequality is a necessary part off the growth process, that it is generally unavoidable and that policy should focus on ensuring that everyone is doing better rather than focusing on narrowing the income gap” whilst other agrue that it hinders growth. This assignment was carried out to investigate and debate the theoretical and empirical views of the above statement as well as share my own views on the debate between income inequality and economic growth.

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Introduction
The relationship between income inequality / distribution and economic growth has been the subject of many studies that have been carried out since the appearance Simon Kuznets work in the 1950s (Turnovsky and Penalosa, 2004:2). Many people are in the view that income inequality is seen as a necessary part of the growth process whilst other economists and analysts argue that income inequality undermines economic growth. Using economic theory and empirical evidence we shall investigate this relationship and express my views on this debate. The theoretical view

Theoretical literature of today stems from Kuznets initial discovery in his 1955 paper Economic ‘Growth and Income Inequality’, presented in The American Economic review, where economic inequality increases over time whilst a country is develops and once a certain level of income per captia is reached inequality begins to decrease. This was the concept that Kuznets hypothesized which led to the creation of the Kuznets Curve (Deininger and Squire, 1998:275), which has been reproduced in APPENDIX A. Hence many are in the view that initial income inequality is acceptable and will eventually “even out” as growth occurred (as seen in APPENDIX A with the inverted U Kuznets Curve). It was due to this theory that many developing countries tolerated these high levels of income inequality arguing that it would become more distributed as growth and development increased (Samanta and Heyse, 2006:1). According to traditional theory, if this inequality does not reverse its self, this inequality in the distribution of income reduces long term growth of the economy through 3 economic mechanisms namely imperfect capital markets, investment in human capital and fertility and domestic market size (Ehrhart, 2009: 4). Due to the high level of income inequality experienced in the early stages of development a phenomenon known as credit rationing occurs (Ehrhart, 2009:5). Credit rationing is essentially when the allocation of loans to creditworthy borrows is done by other means as oppose to pure market means (Friedman, 2000). This rationing occurs due to what Piketty described as the moral-hazard problem and the repayment enforcement problem (Piketty, 1994). The moral hazard problem is due “to the fact that a borrower has little to lose in case of project failure when most of the investment is financed by loan” (Ehrhart, 2009:5). The repayment enforcement problem occurs when the borrower hides returns realized from his/her investment to avoid repayment of the debt used to fund the project (Grossmann and Krueger, 2001:28). In an economy with high income inequality much of the wealth (assets and high income level jobs) is held by “rich” individuals who form a small part of the overall population hence the majority of the population living in poverty (Ehrhart, 2009:7). Due to the above mentioned problems the majority of the population will not have access to credit as they do not have the wealth (assets and low income level jobs) to act as collateral for these loans or make the required monthly, quarterly etc repayments hence the majority of the population will not be seen as creditworthy borrowers (Deininger and Squire, 1997:40). There is a high demand for loanable funds but a low supply (due to harsh credit rationing) hence a high interest rate makes using loans as a method of funding for investments...
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