Financial Complexity, Cycles and Income Inequality

Abstract

We introduce a banking sector and heterogeneous agents in the dynamic over-lapping generations model of Matsuyama et al. (2016). Our model captures thebenefits and costs of an advanced banking system. While it allocates resources toproductive activities, it can also hinder progress if it invests in projects that do notcontribute to capital formation, and potentially triggering instabilities due to theemergence of cycles. Our intergenerational dynamic framework, enables us to showthat income inequality between agents increases during recessions, confirming empiricalobservations. Moreover, we identify both changes in production factor prices andthe reallocation of agents across occupations as driving factors behind the increasedinequality.

Keywords: Banks, Financial Innovation, Cycles, Income Inequality