Capital Flows and Income Inequality

Abstract

We document empirical evidence that surges in capital inflows (outflows) raise (reduce) income inequality. We then introduce a small open economy model that explains these observed links between capital flows and income distribution. Our model features heterogeneous agents and financial frictions, with banks intermediating between household savings and entrepreneur investment.  Capital flows influence income distribution through movements in both capital income and labor income: Inflow surges disproportionately raise returns to entrepreneur investment, while outflow surges boost returns to household savings. Under capital-skill complementarity, capital inflows also increase inequality by raising the skill wage premium.

Keywords: Capital flows, income distribution, heterogeneous agents, capital-skill complementarity, financial frictions, small open economy