Finance:Galor-Zeira model

The Galor-Zeira model is a modern macroeconomic theory about income distribution and its impact on economic growth. It challenges the prevalent neoclassical doctrine that equality inhibits the development of human capital.

Thesis

The Galor-Zeira model describes the inequality-education-growth relationship, explained by the mechanism of unequal access to education due to imperfect capital markets. It claims that this mechanism might lead to a negative effect of inequality on growth. The initial distribution of income determines whether an economy will converge to a low- or high-income regime, as there are multiple steady states in the model.

The model was developed by Oded Galor and Joseph Zeira in 1988, and it was published in the paper “Income Distribution and Macroeconomics”, 1993.

The Neoclassical viewpoint has been challenged in the past two decades, as both theories and subsequent empirical evidence have demonstrated that income distribution has a significant impact on the growth process. In contrast to the representative agent approach which dominated the field of macroeconomics for several decades, the modern perspective, originated by Galor and Zeira (1988, 1993), has underlined the role of heterogeneity in the determination of macroeconomic activity. It has advanced a novel viewpoint that heterogeneity, and thus income distribution, plays an important role in the determination of aggregate economic activity and economic growth in the short-run as well as in the long-run.

Galor and Zeira have demonstrated that in the presence of credit market imperfections, income distribution has a long-lasting effect on investment in human capital, aggregate income, and economic development. Moreover, in contrast to the classical hypothesis, which underscored the virtues of inequality for economic growth, their research advanced the hypothesis that inequality may be detrimental for human capital formation and economic development.

Dynamics of the model

The model consists of four assumptions:

• A good can be produced by either a skilled or unskilled process and skilled workers are more productive. All individuals are born with the same potential abilities with the same preferences. They differ only in the amount they inherit from their parents.
• Individuals live for two periods and each has one offspring.
• In the first period, individuals either invest in human capital and acquire education or work as an unskilled worker. In the second period, they work as skilled or unskilled, according to their decision made in the first period. The decision to invest in education depends on the inheritance from the parent.
• There are imperfect capital markets: due to the need to monitor borrowers, which increases costs, the borrowing interest rate is higher than the lending rate.

There are three possible individual scenarios in the model:

• The individual inherits a higher amount than the cost of education and will invest in human capital. The individual becomes a lender.
• The individual inherits a lower amount than the cost of education, but finds it profitable to borrow money to invest in human capital. The individual becomes a borrower.
• The individual inherits a much lower amount than the cost of education and finds it unprofitable to invest in human capital, due to higher costs of borrowing. As a result, education is limited to individuals with sufficiently high initial wealth. If credit markets were perfect, every individual would be able to borrow money to invest in human capital.

Long-run implications

The economic situation of each dynasty depends on its initial wealth, due to credit markets’ imperfections and an indivisibility in investment in human capital. In rich dynasties, all generations invest in human capital, work as skilled and leave a large inheritance to their children. In poor dynasties people inherit less, work as unskilled, and leave less to the next generation. They can get stuck in a poverty trap. Thus, the initial distribution of wealth determines the size of these two groups: the rich and the poor dynasties. As a result, it also determines GDP, as skilled are more productive. Therefore, inequality may negatively affect macroeconomic activity and economic development due to “intergenerational transfers and their effect on the persistence of inequality”.

Policy implications

A government policy can change the long-run equilibrium. The government can subsidize education, which reduces the individual cost of education and finance it by taxing those who study and become skilled. This increases human capital investment in the short- and long-run, increases GDP and is a Pareto improving policy. The model gives an explanation to the rise of public education.

Realistic application

According to the Galor-Zeira model, the wealth-equality relationship works three ways:

• Richer economics tend to have smaller wage differentials and more equal distribution of income.

That means, wealth and equality are highly correlated and affect one another. On the one hand, countries with a greater income per capita have more equal distribution of income and smaller wage differentials. On the other hand, countries with more equal initial distribution of wealth and have higher income level in the long run.

• The effect stressed by the model is mitigated by public education, which makes wealth less necessary for access to education. Hence, the effect of inequality on growth is expected to be higher in poor countries than in rich countries.
• Economics with unequal income distribution suffer a permanent income and utility loss as a result of shock and their distribution of income becomes even more unequal.

Acknowledgments

The Oxford University Press named the Galor-Zeira paper("Income Distribution and Macroeconomics") among the 11 most path-breaking papers published in The Review of Economic Studies in the past 60 years.

See also

• Income distribution
• Capital market imperfections
• Economic growth
• Economic inequality