Inequality, Credit Market Imperfection, Segmentation and Economic Growth

This paper investigates how initial inequality can causally affect economic growth when moral hazard problems exist in credit markets.Two regimes of the credit markets aiming at overcoming the moral hazard problems are analyzed.The formal one such as bank relies on intermediary between borrowers and lenders by asking for collateral.The informal one relies on direct yet costly monitoring by the lenders themselves.However, from the social point of view both of them are unfavorable to certain segments of the agents in this heterogenous economy in terms of whether the individual potential productivity could be fully realized. Consequently, the permission of the coexistence of these two regimes could be growth enhancing.The dynamic rise and fall of the formal and informal regimes are implied along the growth process of per capita income.In the empirical part, the negative relationship between initial inequality and long run growth is discovered, using cross-province data in rural China rather than more often used cross-country data sets in literature.Interestingly, the policy dummy variable telling the permission or forbidding of the informal regime presents a positive sign.Both of these two results support our theoretical model empirically. Finally, we argue that this channel to bridge inequality and economic growth is more rural specific.