ChainWhat it assumes · how to break it
Start
Income inequality rises, for example because pay for highly skilled workers grows much faster than pay for low-skilled workers as technology changes.
1
As a result, a larger share of national income goes to high-income households.
distribution of income
distribution of income
Assumes: Total income is unchanged while its distribution shifts.
But: If the change comes with faster productivity growth, everyone's income may rise even as the gap widens.
2
Since high-income households have a lower marginal propensity to consume than low-income households, more of each pound is saved rather than spent.
marginal propensity to consume · saving
marginal propensity to consume · saving
Assumes: Lower-income households do not borrow to keep spending.
But: If lower-income households borrow to keep up their consumption, spending may hold up for a time, though household debt builds up.
3
Consequently, consumption grows more slowly for any given level of national income, so aggregate demand grows more slowly.
consumption · aggregate demand
consumption · aggregate demand
Best link to attack
Assumes: The extra saving is not turned into investment.
Assumes: The extra saving is not turned into investment.
But: If the extra saving flows through banks and financial markets into business investment, total AD is maintained and the capital stock rises.
4
Therefore, firms see weaker demand, cut back on investment through the accelerator, and economic growth slows.
accelerator · economic growth
accelerator · economic growth
Assumes: Firms base investment on expected demand.
But: If firms expect strong global demand or new technology to pay off, they may invest regardless of weaker domestic consumption.
End
Aggregate demand grows more slowly and economic growth may slow.
Evaluation chain
- E1However, the fall in growth depends on whether the extra saving by richer households is lost from the circular flow.
- E2If the saving is lent to firms through banks and financial markets, then investment rises to replace the lost consumption.
- E3As a result, AD is maintained and the capital stock grows, while higher rewards for skills may also encourage training and effort.
- E4So rising inequality slows growth mainly when saving is not matched by investment, as in a downturn, and may even support growth when investment opportunities are strong.
Another way to attack it: High inequality can also limit growth from the supply side: if poorer families cannot afford education and training, talent is wasted and productivity grows more slowly.
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Questions this answers
- Assess the view that rising inequality reduces economic growth.
- Discuss whether some inequality is necessary for economic growth.
- Explain how a change in the distribution of income can affect consumption.
Diagram
AD/AS diagram: AD shifts right by less than it otherwise would, so real GDP grows more slowly.
Reverse and related
Falling inequality → more income to households with a high MPC → consumption and AD rise, although incentives to invest and take risks may weaken.