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Earnings Inequality and the Equity Premium

Author

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  • Walentin, Karl

    (Research Department, Central Bank of Sweden)

Abstract
We present data from the Survey of Consumer Finances showing that the increased earnings (labor income) inequality, in combination with increased stockmarket partic- ipation, has roughly doubled stockholders’share of aggregate labor income in the last four decades. We explore the impact of the increase in this share on returns to equity and returns to a risk-free bond in a model with limited stockmarket participation, labor income and borrowing constraints. The main result is that the increase in stockholders’ share of aggregate labor income has lead to 130 basis points (45 percent) decrease in the ex ante equity premium (i.e. the discount rate applied to equity). The reason for this change is that the increase in stockholders’share of aggregate labor income leads to a change in income composition for stockholders - an increase in the fraction of their income that consists of labor income and a decrease in the fraction that consists of dividend income. This reduces the covariance between stockholder income growth and dividend growth. The size of the decrease in the equity premium implied by our model roughly coincides with the historical change in the post-1951 equity premium implied by the simple dividend growth model in Fama and French (2002).

Suggested Citation

  • Walentin, Karl, 2007. "Earnings Inequality and the Equity Premium," Working Paper Series 215, Sveriges Riksbank (Central Bank of Sweden).
    • Handle: RePEc:hhs:rbnkwp:0215
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    References listed on IDEAS

    as
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    Cited by:

    1. Kevin J. Lansing, 2011. "Asset pricing with concentrated ownership of capital," Working Paper 2011/18, Norges Bank.
    2. Favilukis, Jack, 2013. "Inequality, stock market participation, and the equity premium," Journal of Financial Economics, Elsevier, vol. 107(3), pages 740-759.
    3. Horvath, Roman & Kaszab, Lorant & Marsal, Ales, 2021. "Equity premium and monetary policy in a model with limited asset market participation," Economic Modelling, Elsevier, vol. 95(C), pages 430-440.
    4. Peng, Yulei & Zervou, Anastasia, 2022. "Monetary policy rules and the equity premium in a segmented markets model," Journal of Macroeconomics, Elsevier, vol. 73(C).
    5. Agnieszka Markiewicz & Rafal Raciborski, 2022. "Income Inequality and Stock Market Returns," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 43, pages 286-307, January.
    6. Grand, François Le & Ragot, Xavier, 2018. "A class of tractable incomplete-market models for studying asset returns and risk exposure," European Economic Review, Elsevier, vol. 103(C), pages 39-59.
    7. Yulei Peng & Anastasia Zervou, 2014. "Monetary Policy Rules and the Equity Premium," Working Papers 20141115_001, Texas A&M University, Department of Economics.
    8. Zervou, Anastasia S., 2013. "Financial market segmentation, stock market volatility and the role of monetary policy," European Economic Review, Elsevier, vol. 63(C), pages 256-272.
    9. Hazra, Devika, 2022. "Does monetary policy favor the skilled? − Distributional role of monetary policy," The Quarterly Review of Economics and Finance, Elsevier, vol. 86(C), pages 65-86.
    10. Atolia Manoj & Kurokawa Yoshinori, 2021. "Entry Costs, Task Variety, and Skill Flexibility: A Simple Theory of (Top) Income Skewness," The B.E. Journal of Macroeconomics, De Gruyter, vol. 21(1), pages 97-124, January.
    11. Hazra, Devika, 2018. "Distributional role of monetary policy under limited credit access," Research in Economics, Elsevier, vol. 72(4), pages 494-510.

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    More about this item

    Keywords

    labor income; earnings inequality; asset pricing; equity premium; limited participation; borrowing constraints;
    All these keywords.

    JEL classification:

    • D31 - Microeconomics - - Distribution - - - Personal Income and Wealth Distribution
    • E24 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Employment; Unemployment; Wages; Intergenerational Income Distribution; Aggregate Human Capital; Aggregate Labor Productivity
    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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