Macroeconomic Implications of Inequality and Income Risk

We explore the long-run relationship between income risk, inequality, and the macroeconomy in an overlapping-generations model in which households face uncertain streams of labor income and returns on their savings. To manage those risks, households can apportion their savings to a bond, whose return is safe and identical across households, and a productive asset, whose return is uncertain and can differ persistently across households. We find that greater polarization in households’ labor income and returns on their savings generally accentuates households’ demand for risk-free assets and the compensation they require for bearing risk, leading to higher measured income and wealth inequality, a lower risk-free real interest rate, and higher risk premiums. These findings suggest that the factors behind the observed rise in inequality over the past few decades might have contributed to the observed fall in the risk-free real interest rate and widening gap between the risk-free real interest rate and the rate of return on capital. We also find that the magnitude of the decline in the risk-free real interest rate and offsetting rise in risk premiums depend importantly on the source of income polarization, with the effects being especially large when greater inequality is caused by increased dispersion in returns on risky assets. Thus, the macroeconomic implications not only depend on the amount of inequality, but also the source of this inequality.