Turns inequality

4. Effects of Inflation on Income Inequality In the previous section we presented empirical evidence of the relationship between inflation and income inequality. Of course, correlation does not imply causation; however, there are also strong theoretical arguments that inflation may contribute to the rise of income inequality.

First, inflation decreases the real value of social benefits (Yeager, 1997a). Because of imperfect indexation (e.g. due to the fact that the index is the past inflation rate), the nominal value of social benefits lags behind price changes reducing the real income of the beneficiaries. People receiving social benefits generally have low incomes (Romer, Romer, 1998); therefore, inflation contributes to income inequality.

Second, in countries with progressive income taxes, which prevail nowadays, inflation leads to bracket creep (Wilson, 1982). It raises the effective tax rate for people not initially in the highest tax bracket, thus leading to increasing income inequality.

Third, inflation reduces the value of cash and leads to other forms of storage of wealth. Empirical evidence shows the fraction of household wealth held in liquid assets decreases with income and wealth (Kennickel, Starr-McCluer, 1996). Mulligan, Sala-iMartin (2000) found the probability of hedging against inflation by adopting financial technologies is positively related to the level of household income and wealth. Moreover, wealthier people are more able to economize on cash because they face a lower perunit cost of banking services and “lower per unit cost of credit purchases than their low income counterparts since they consume more than low income households” (Erosa, Ventura, 2002, p. 3).

The above effects are important,7 however, we should not forget that the money supply never enters the economy in a uniform way and never affects prices evenly. In reality the money supply is unevenly distributed into the economy, that is, only through certain channels, affecting different prices in a non-uniform way. This effect is called the Cantillon effect, because Richard Cantillon (1775) was the first to describe it, or alternatively the first-round effect or injection effect. Thus, the Cantillon effect is the non-neutral effect of money resulting from the fact that newly created money is neither evenly nor simultaneously distributed among the population. Therefore, the expansion of the money supply affects the structure of relative prices and leads to changes in resource allocation and distribution of income and wealth. It “can hardly be doubted: monetary expansion cannot leave all real quantities and all relative prices the same as they would otherwise have been. New money enters the economy in a particular way and has differential impacts.” (Yeager, 1997b, p. 253) Although inflation entails some effects even if it is uniform, the Cantillon effect should be regarded as more central. Indeed, if money were neutral, there would be no need to increase the money supply.

How does this effect operate, and how does it lead to a rise in income inequality? The first main channel of such inflationary redistribution is from the late to the early recipients of newly created money. The first recipients have higher cash balances, while the prices of their purchases have not yet changed. Therefore, they can purchase more goods and services. However, as new money spreads through the economy, prices are bid up, which means that late recipients face higher prices.

This effect may explain why financial markets – which, thanks to credit expansion, are the very first recipient of any new money supply – in virtually all developed countries have grown faster than the real economy for most of the past century. Since 1980, the US financial sector’s share in GDP increased at a faster rate (13 basis points per annum) than it did in the prior 30 years (7 basis point per annum) (Greenwood, Scharfstein, 2012). Accordingly, the US financial services industry grew from 4.9 per cent of GDP in 1980 to 7.9 per cent of GDP in 2007, while market capitalization of equities grew from 50 per cent to 141 per cent of GDP (Greenwood, Scharfstein, 2012).

The impact on income inequality seems to be obvious now. The injection of money into the financial sector augments the salaries of people employed in this sector. In 1980, the typical financial services employee earned roughly the same wage as comparable employees in other industries, while in 2006 the typical wage in the financial sector was an average of 70 per cent higher than in the rest of the economy (Greenwood, Scharfstein, 2012). Similarly, in the finance, insurance, and real estate sectors, employment as a share of total private sector employment rose from 6.6 per cent in 1979 to 7.3 per cent in 2005 (Palley, 2007), while the ratio of CEO pay to average worker pay increased from 27 in 1973 to 300 in the year 2000 (Gordon, Dew-Becker, 2005). These facts may confirm the thesis of Piketty, Saez (2003) that the rise of income inequality in the United States since the 1970s has been caused mainly by a surge in top wages, including the wages of financial professionals.