Income Inequality and Asset Prices: A Cross-Country Study

Abstract:     
In this paper I study the asset pricing implication of cross-country differences in income inequality. Using panel regression with year fixed effects, I document a strong negative relationship between cross-country stock market levels (as measured by each market’s P/D ratio) and cross-country income inequality levels after controlling for an extensive set of variables including conventional risk factors, country characteristics and degree of global market segmentation. I argue that this relationship should be interpreted as the negative impact of inequality on market price. This effect is both statistically and economically significant: On average, one unit increment in inequality (a 0.01increament in income Gini, which ranges between 0 and 1) is shown to decrease the market P/D ratio by up to 2%. The inverse relationship between income inequality and price is stronger in developed countries than in developing countries. It is robust to alternative measures of stock market levels and income inequality. By decomposing price into expected excess returns and risk-free rates, I empirically identify the main channel through which inequality influences price: The inverse relationship observed between inequality and P/D ratio can almost be completely attributed to strong positive link between income inequality and interest rates; while I find no supporting evidence that cross-country excess returns are correlated with income disparities. These findings have important implications both for asset pricing modeling and for policy making.

Number of Pages in PDF File: 51

Keywords: income inequality, asset pricing, cross-country

JEL Classification: D63, G12

working papers series