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No 1108:
The Inequality Accelerator

Eric Mengus and Roberto Pancrazi

Abstract: We show that the transition from an economy characterized by idiosyncratic income shocks and incomplete markets la Aiyagari (1994) to markets where state-contingent assets are available but costly (in order to purchase a contingent asset, households have to pay a fixed participation cost) leads to a large increase of wealth inequality. Using a standard calibration our model can match a Gini of 0.93 close to the level of wealth inequality observed in the US. In addition, under this level of participation costs, wealth inequality is particularly sensitive to income inequality. We label this phenomenon as the Inequality Accelerator. We demonstrate how costly access to contingent asset-markets generates these effects. The key insight stems from the non-monotonic relationship between wealth and desired degree of insurance, in an economy with participation costs. Poor borrowing constrained households remain uninsured, middle-class households are almost perfectly insured, while rich households decide to self-insure by purchasing risk-free assets. This feature of households' risk management has crucial effects in asset prices, wealth inequality, and social mobility.

Keywords: Wealth inequality; Participation costs; Insurance; (follow links to similar papers)

JEL-Codes: D31; E21; G11; (follow links to similar papers)

45 pages, September 15, 2015

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