Investment Shocks and Inequality Dynamics

We explore the dynamics of income and income inequality under asymmetric information in credit markets. Within a stochastic overlapping-generations framework, we study the investment decision of entrepreneurs with heterogeneous abilities. Under information asymmetry, banks do not observe entrepreneurial ability and offer a single pooled loan contract to all entrepreneurs. We show that, following a negative investment shock, the average quality of the entrepreneur pool improves and banks optimally react by lowering the pooled borrowing rate. This reduction in the borrowing rate mitigates the drop in entrepreneurs' income. Consequently, after a negative investment shock, income inequality decreases less compared to the case of full information. Our findings therefore suggest that information asymmetry lessens the fluctuations in income inequality.