Financial Development, Income Inequality, and Trade

ABSTRACT This study examines the impact of financial development (FD) on income inequality in a general‐equilibrium model with credit constraints and international trade. I show that a single mechanism—the interaction between financial and trade selection effects—reconciles a range of seemingly conflicting results: FD always reduces inequality between entrepreneurs and workers, but its effect on inequality among entrepreneurs switches from monotonically increasing to U‐shaped as trade costs fall. Extending the model to countries that differ in FD and technological potential, I find that the country with better FD has higher wages but lower average entrepreneurial income. This wage advantage can, however, be overturned by a technological disadvantage, offering an explanation for the mixed cross‐country evidence on FD and inequality. Moreover, FD‐related policies can enhance equality and efficiency simultaneously in the global economy.