Inequality and Exchange Rate Movements in an Open-Economy Macroeconomic Model

ABSTRACT

This article presents a complete macroeconomic (SFC) model to study income and wealth distribution in an open economy. We argue that exchange rates and the stock of foreign debt play a major role in shaping inequality across and within countries. Using the ‘relative income hypothesis’, we show that debt-financed consumption of low-income households can affect both total income and the disposable income of high-income households in the medium run. In addition, while higher inequality is detrimental to the domestic economy, it can benefit trading partners.

KEYWORDS:

• Open economy
• inequality
• foreign investments
• stock-flow consistency

JEL CODES:

• E17
• E21
• F31
• F32
• F41

Disclosure Statement

No potential conflict of interest was reported by the authors.

Notes

1 Regressions are made using US Census data for the 50 states and the 100 more populous counties in the period between 1990 and 2000, when a steep increase in inequality was recorded.

2 For the sake of simplicity, the interest rate on loans to households is equal to the interest yielded by government bills.

3 Since the model is symmetrical, we omit the equations for the other country, the US.

4 We start from equation (7) because we follow the numbering of the complete list of equations featured in the Appendix.

5 Total gross wealth equals net wealth plus the stock of debt (loans).

6 For this purpose, we change $\mathrm{em}{u}^{\text{€}}$ from 0 to 0.15. Notice that the assumption of country-specific imitation parameters, as proposed by Belabed, Theobald, and van Treeck (2018), can be extended to justify time-specific imitation parameters within the same country.

7 Income (wealth) inequality is calculated as the ratio of the income (wealth) perceived by the top 50 per cent to total income after taxes (wealth).

8 The primary distribution of income is income net of interest payments and other financial incomes.

9 The wage equation coefficient $w_2^{\mathrm{\$}}$ is reset to –0.2. This brings about lower wages for low-income households and higher profits for high-income households.

10 Clearly, this is just a ‘mental experiment’ focusing on (theoretical) intra-period disequilibria before the change in the exchange rate.

11 This comment is actually less trivial than it looks at first sight. It is true that income inequality has been exogenously increased. However, this only relates to the primary distribution of wages, being bank profits and interest rates of bonds related to stocks determined endogenously. Consequently, as in Cardaci and Saraceno (2016), even if the level of inequality is ‘shocked’ exogenously, stocks ‘might allow income distribution to change endogenously’ (p. 19). Tracking the evolution of inequality in disposable incomes makes sense precisely because this second endogenous component is incorporated.

12 Simulated series for the US and the EA are dollars and euros, respectively. However, absolute values of simulated series do not match observed values because the aim of the model is to detect trends and allow for a dynamic comparative analysis, rather than to predict actual levels.

13 Notice that flight-to-safety behaviours can be explicitly reproduced by endogenising the parameters of portfolio equations in our model. However, we chose to ignore this complication as the model is already replicating major stylised facts.

14 This requires the price elasticity of imports and exports to be high enough. For a thorough discussion of this point and a criticism of the standard Marshall–Lerner condition, we refer to Carnevali, Fontana, and Veronese Passarella (2020).

15 The US current account does not become positive, as happens in our simulations. The reason is that the US dollar appreciation was strengthened by the flight-to-safety of foreign capital (see footnote 12). In addition, US exports were also hit by the global crisis.