Macroeconomics & inequality
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Date
31/01/2023Author
Tyrrell-Hendry, Lee
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Abstract
This thesis explores inequality and its effects on the macroeconomy. Each chapter is
concerned with heterogeneity between households or firms in some dimension: the first
simply explores whether a standard model can capture the degree of inequality observed
in the data; the second and third tackle the implications of such inequality for some
aspect of policy. In all three papers I adopt the approach now common in the literature
of viewing inequality as arising from idiosyncratic shocks and incomplete markets. In
this lay summary I briefly discuss each chapter.
MATCHING THE WEALTH DISTRIBUTION WITH INCOME INEQUALITY & RISK: I show that a
standard incomplete markets model with labour income risk alone, when modelled accurately
using a new method, can broadly match the distribution of wealth observed in the US and UK,
whereas adding capital income risk does little to concentrate wealth further; both findings are
in contrast to the prior literature. Moreover, I show that increased labour income inequality
and risk can account for around a third of the rise in the concentration of wealth among the
top 1% in the US since the 1970s, and about 0.5pp of the decline in real interest rates.
SHOULD I STAY (IN SCHOOL) OR SHOULD I GO (TO WORK): How should governments
calibrate the desire for redistribution via progressive taxation against the need to incentivise the
accumulation of human capital through schooling? I explore this question in a heterogeneous
agent model featuring stochastic human capital accumulation, endogeneous labour supply and
an education choice modelled as a stopping time problem, where agents choose an optimal
number of years to study before starting work. The latter feature addresses a shortcoming of
much of the literature that typically models education decisions as a time allocation problem
– which overstates the ability of older workers to insure themselves against obsolesence of their
human capital and hence understates the welfare benefits of public insurance, for example
through progressive taxation – or as a stylised problem with no resource or opportunity costs,
which understates the bite of financial frictions, and hence the potential welfare gains from
subsidising higher education. The social welfare-maximising policy features generous subsidies
for education and highly progressive labour taxes. This result is robust to myriad extensions,
including weakening the extent of financial frictions by allowing students to borrow.
EM FOREVER BLOWING BUBBLES: GLOBAL IMBALANCES & THE LIMITS OF FISCAL SPACE:
What are the limits on how much a government can borrow when the real interest rate on
public debt is below the growth rate of the economy? I explore this question in a framework
where household entrepreneurs make risky investments under incomplete markets. Such risks
induce them to engage in precautionary saving, which lowers equilibrium interest rates and
hence expands the fiscal space available to governments. I expand on the prior literature by
introducing emerging market (EM) economies – where entrepreneurs face even greater risk and
hence engage in more aggressive precautionary saving – as well as limits to the private supply
of safe assets. Both elements reduce equilibrium real interest rates in the developed world
and further inflate the bubble in public debt, affording developed market (DM) governments
even greater fiscal space. I quantify the extent of fiscal space available to governments: how
much debt they can issue without having to run surpluses, or how large a deficit they can
sustainably run. But I also show that such borrowing carries risks, and governments must
design fiscal rules to ensure their debt is both stable in the short run and sustainable in the
long run, and that moreover that such policies are in general not Pareto-improving.