Published in
Memorandum No. 27/2011, Department of Economics, University of Oslo
Abstract
This paper studies the determinants of inequality in an infinitehorizon general equilibrium model. Missing capital markets decreases motivations for capital accumulation among the poor, while uncertainty about future income leads to precautionary savings. Hence, the degree of polarization in the wealth distribution depends critically on the level of risk in the economy. With low risk, there are two distinct population groups: the poor and the rich. There is no mobility between groups, and the wealth distribution is history dependent. With high risk, there is mobility between groups and a unique steady state. When comparing welfare across steady states with different parameters, the rich and the very poor prefer economies where risk is low. The middle class, on the other hand, is better off if risk is higher. The effects are stronger in societies with a larger poor population. This comparison offers a new perspective on why social security systems emerge even in societies where the poor have limited democratic voice.