Idiosyncratic and aggregate risks, inequality and growth

Abstract

The paper disaggregates productivity shocks at a firm level into idiosyncratic and aggregate risks, and studies their impacts on inequality, growth and welfare. It develops a growth model with human capital and incomplete insurance and credit markets that provides a closed-form solution for income inequality dynamics. We find that uninsured idiosyncratic risks are the most important determinants of inequality, growth and welfare. They are the source of nondegenerate wealth distribution. A lower weight of these shocks leads to lower steady-state inequality, higher growth and welfare. A redistribution of income that serves as social insurance against such risks increases welfare and decreases inequality. But, it also decreases growth by distorting individual consumption and saving decisions.