Since the 1990s, poverty rate worldwide has been halved from 43% to 21% in 2010. More than a billion people in the developing world have been lifted out of poverty (Economist, 2013). Most of the growth was driven by China and India which have lifted 716 million people put of poverty. This 'economic miracle' has been unprecedented and represents an opportunity for developing country to achieve economic development.
However, as these countries have grown stupendously, another concerned have emerged among policy makers and economists. Countries, regardless of developing or developed countries are facing greater income inequality. Even countries such as Finland and Denmark which are know to be egalitarian, have seen an increase in income inequality. Sweden, meanwhile, have seen the steepest increase in measure of inequality among 34 OECD countries (OECD, 2011).
On the other hand, 4 out of 5 of Asia most populous countries -India, China, Bangladesh and Indonesia- have seen income inequality gone up since 1990s (Asian Development Bank, 2012). This is a bigger issue for developing countries as effects of inequality can have major implications on economic development. Developing countries around the world have an objective of increasing income levels or GDP, reducing poverty and increasing living standards measured by social indicators such as literacy rate, schooling years, and life expectancy. The efforts to reach these objectives are then hampered by increasing income inequality.
I will explore the relationship between income inequality and economic development by looking at three channels on how income inequality might do so. The three channels are impact of inequality on economic growth, poverty and socio-politics.
Income Inequality and Economic Growth
Before I look at how income inequality might affect economic growth, it is pivotal to understand how economies grow. To help us understand that, I will look at two prominent growth theories; Solow-Swan growth model and Endogenous growth model.
The Solow-Swan Growth Model was introduced in 1956 by Robert Solow and Trevor Swan . Under this growth theory, countries that save more will be able to invest. In the neoclassical model, an increase in saving rate leads to a decrease in interest rate. As a consequence of this, the economy is able to invest more and achieve a higher level of income.
Hence, we have to look at the relationship between saving rate and income inequality to understand the affects of the latter on economic growth. Research (Dynan, Skinner, & Zeldes, 2004) have shown that as people get richer they tend to save more. Not only their savings are high, but their marginal propensity to save also increases. It can be inferred that since the rich do save more, greater income inequality, where wealth is concentrated in the hands of a few, is better under the Solow growth model. Countries such as China, India, and South Korea to name a few, that have had high growth rate, have saved...