How Does Financial Development Affect the Growth–Inequality Nexus? Evidence from a PCHVAR Analysis

While the important role of financial development for economic growth, as well as for its effect on economic inequality, has been widely acknowledged by the literature, far less attention has been put on understanding how growth and inequality may be differently influenced by alternative types of financial development. Against this background, we investigate the impact of different types of financial development on the growth–inequality nexus with a panel of 110 advanced and emerging economies and yearly data ranging from 1980 to 2016. Using the panel conditionally homogeneous vector-autoregressive (PCHVAR) model of Georgiadis (2014); Georgiadis (2012), we find that the overall level of financial development (measured by the International Monetary Fund (IMF)’s financial development index) has a significant impact on the growth–inequality nexus. Specifically, our results reveal that a higher level of overall financial development results in more equitable economic growth. Furthermore, an increase in the income share of the top 10% income earners has a significant negative impact on economic growth for low and high levels of overall financial development but is insignificant for middle levels. By looking at more disaggregated subindices of financial development, we find that economic growth increases the income share of the low 10% income earners when financial institutions and markets are deeper and financial markets are more efficient. Thus, our results call for a more differentiated view on the concept of financial development in order to derive policy measures aimed at different parts of the society.