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Financial Development and Income Inequality: Does Inflation Matter
Applied Economics Quarterly, Vol. 58 (2012), Iss. 3 : pp. 193–212
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University of Leicester, Department of Economics, University Road, Leicester, LE1 7RH.
Abstract
Inflation reduces the ability of financial intermediaries to improve resource allocation. Therefore, this study examines whether the effect of financial development on income inequality ceases as inflation rate rise. The study uses dynamic panel data of 60 countries over a period of 1980–2009 and applies a system GMM estimator. The results show that financial development reduces income inequality. Nevertheless, the gains from financial development are offset by inflation. As inflation becomes severe, financial development ceases to reduce income inequality. This is because high inflation levels intensify credit rationing through reduction and greater variability of real returns. Consequently the financial sector makes few loans, resource allocation becomes ineffcient, and intermediary activity declines with adverse implications for income inequality. The results are robust to different measures of financial development.
JEL Classification: G2, O11, E31