Wealth Inequality, Stock Market Participation, and the Equity Premium
London School of Economics & Political Science (LSE)
April 30, 2012
Journal of Financial Economics (JFE), Forthcoming
The last 30 years saw substantial increases in wealth inequality and in stock market participation, smaller increases in consumption inequality and the fraction of indebted households, a decline in interest rates and in the expected equity premium, as well as a prolonged stock market boom. Understanding the causes of these trends is crucial for many questions in finance and economics. In an incomplete markets, overlapping generations model we show that these trends can be jointly explained by the observed rise in wage inequality, as well as a decrease in participation costs and a loosening of borrowing constraints. Once we account for these changes, we show that the observed pattern of stock prices played a major role in increasing wealth inequality because stockholders, who tend to be wealthy, benefit most from a bull market. Crucially, these phenomena must be considered jointly; studying one independently leads to counterfactual predictions about others. For example, a loosening of credit standards is expected to raise, rather than lower interest rates through decreased precautionary savings as well as vastly increase the fraction of households in debt; an increase in labor inequality is (somewhat counterintuitively) expected to lower rather than raise wealth inequality, again through precautionary savings; increased stock market participation should also lower wealth inequality.
Number of Pages in PDF File: 56
Keywords: Inequality, Limited Participation, Equity Premium
JEL Classification: E21, E44, G12Accepted Paper Series
Date posted: November 5, 2012
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