Seminar Papers,
Stockholm University, Institute for International Economic Studies

Abstract: This paper studies the relationship between investor protection, the development of financial markets and income inequality. In the presence of market frictions, investor protection promotes financial development by raising confidence and reducing the costs of external financing. Developed financial systems spread risk among financiers and firms, allocating them to the agents bearing them best. Therefore, financial development plays the twofold role of encouraging agents to undertake risky enterprises and providing them with insurance. By increasing the number of risky projects, it raises income inequality. By extending insurance to more agents, it reduces it. As a result, the relationship between financial development and income inequality is hump-shaped. Empirical evidence from a cross-section of sixty-nine countries, as well as a panel of fifty-two countries over the period 1976-2000, supports the predictions of the model.

Keywords: Income inequality; financial development; capital market frictions; investor protection; instrumental variables; dynamic panel data

JEL-codes: D31; E44; G30; O15; O16

45 pages, May 11, 2005

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