Endogenous borrowing constraints and wealth inequality

This paper studies the evolution of wealth inequality in an economy with endogenous borrowing constraints. In the model economy, agents need to borrow to finance human capital investments but cannot commit to repaying their loans. Creditors can punish defaulters by banishing them permanently from the credit market. In equilibrium, loan default is prevented by imposing a borrowing limit tied to the borrower’s inheritance. The heterogeneity in inheritances translates into heterogeneity in the borrowing limits: endogenously, some young borrowers face a zero borrowing limit, some are partly constrained, while others are unconstrained. Depending on the initial distribution of inheritances, it is possible all lineages are attracted to either the zero-borrowing-limit steady state or to the unconstrained-borrowing steady state — long-run equality. It is also possible some lineages end up at one steady state and the rest at the other — complete polarization. Interestingly, the wealth dynamics in the model closely resemble that in the seminal work of Galor and Zeira (1993). JEL Classification Numbers: E62, E25, O23, O41, E44.