Income Inequality and Economic Growth

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Chapter 1: Introduction

Economic growth is the result of abstention from current consumption. An economy produces a variety of commodities, and then income is generated through sales of products. The very same income is used to buy other products which generate income for other producers.

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The very same income is used to buy a variety of commodities. The producers decide what to produce depending on their individual preferences and the distribution of income, initial endowments. In general, commodity production creates income, which creates the demand for those very same commodities. The cycle of production, consumption, saving, and investment that constantly regenerates itself is as old as human civilisation. In some cases, savers and investors are exactly the same individuals, using their own funds; in other cases, they are not. (51, Ray) The income inequality occurs because people in an economy differ from each other in many ways that are relevant to their incomes. These differences can be in forms of human capital (education and health), in where people live, in their ownership of physical capital, in the particular skills they have, and even in their luck. As explained above, economic growth and income inequality have a huge influence on each other. That is why there have been extensive studies in income distribution and its effect on other economic variables. Income distribution has always been considered to be an important topic because it tells us how incomes are distributed among the members of a population and allows the government to determine tax policies for redistribution to decrease inequality, or to implement social policies to reduce poverty. However, there are many debates about how reliable data is because they mainly are collected through surveys and the sources of errors are numerous. Furthermore, the income distribution measure, income gini-coefficient, does have its disadvantage because the best fit line method is used when representing the Lorenz curve which is used to calculate gini-coefficient. As outliers are ignored when a best-fit line is illustrated, the population in extreme poverty will not be accounted in income inequality measure. Thus, the measure of inequality may not be as accurate as it is believed to be. Because of these data features, it is important to complement classical statistical procedures with robust ones. (Maria-pia, Victoria-Feser, 2000)

No concrete theory yet exists to explain the relationship between income inequality and economic growth. Most empirical research on income inequality and economic growth tends to focus on imperfect market, the politics of redistribution, the size of the market. Benabou (1996) and others argued that imperfect capital markets can slow the economic growth by increasing the level of inequality. The main input of economic growth is investment generated by savings or borrowing credits. A result of imperfect capital markets is that the poor credit applicants with high expected rate of return projects have limited access to credit compared with rich applicants with the lower profitable projects.

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