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Galor-Zeira model

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 advocates the 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.

The model was developed by Oded Galor and Joseph Zeira in 1991, who explained the model in the paper “Income Distribution and Macroeconomics”, 1993.

Dynamics of the model

The model consists of four assumptions:

• A good can be produced by either a skilled or unskilled process.
• Individuals live for two periods.
• 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 or not depends on the inheritance from the previous generation.
• There are imperfect capital markets: the borrowing interest rate is higher than the lending rate.

There are three possible 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 lower amount than the cost of education and finds it unprofitable to invest in human capital, due to higher borrowing interest rate.

Education is limited to individuals with high enough initial wealth. If credit markets would be perfect, every individual would be able to borrow money to invest in human capital.

Long-run implications

The economic situation of dynasties (consisting of one parent and one child) depends on initial wealth, due to credit markets’ imperfections and indivisibilities in investment in human capital. In rich dynasties, all generations invest in human capital, work as skilled and leave a large inheritance. In poor dynasties people inherit less, work as unskilled, and leave less to the next generation. They can get stuck in a poverty trap. The initial distribution of wealth determines the size of these two groups: the rich and the poor dynasties. This results in either a rich or a poor long-run equilibrium. Therefore, inequality may negatively affect macroeconomic activity and economic development due to “intergenerational transfers and their effect on the persistence of inequality”.

Policy adjustments

A government policy can change the long-run equilibrium. The government can subsidize education, which reduces the individual cost of education. This increases human capital investment in the short- and long-run.

Realistic application

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

• Richer economies tend to have smaller wage differential and a more equal income distribution.
• Income distribution affects the behaviour of economies to economic shocks, because they require investment in human capital and sectorial shifts. Higher saving or lower population growth, both a source of higher income per capita, leads to a higher level of income and thus a higher level of human capital.

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

References

Category:Economics Category:Economic inequality Category:Income distribution