International Finance Discussion Papers

When per capita income is low, increases in income inequality make macroeconomic cycles less severe. We present a model in which access to credit is based on earnings potential. If low as well as middle income individuals are credit constrained, increases in income inequality lead to smaller fluctuations in aggregate consumption and output. Empirical evidence from cross-country data supports the view that greater income inequality causes lower variation of real consumption and output growth in low income countries. When per capita income is high, however, this effect is reversed.