2. Relationship among Economic Growth, Poverty and Inequality
Inequality and Poverty on Economic Growth
The three main theories that relate income distribution, poverty and economic
growth are a) savings rate argument b) credit market imperfection argument and c)
political economy argument. The Harrod Domar model, which is based on the savings
rate theory, predicts that a higher income inequality leads to higher economic growth.
According to this strand of literature, the savings rate in an economy is directly
proportional to income level. Thus, a richer person saves on average a larger fraction of
his or her income than a poorer person does. Consequently, concentrating income in the
hands of a few rich people can maximize the aggregate savings rate in an economy
compared to an equitable income distribution among the population. Fields (1989)
maintains that inequality leads to higher growth as one of his null hypothesis.1 The
implicit assumption in these models is that a higher savings rate translates to higher
investment (leading to higher economic growth), which is not necessarily true for all
economies, particularly for small open economies.
According to credit-market imperfection theory, inequality curtails the ability of
people to accumulate human and physical capital. In general, people’s income level and
possession of assets largely determine their access to credit markets. Therefore, people in
unequal societies typically face borrowing constraints that preclude them from investing
in human and physical capital. Stocks of physical and human capital in an unequal
society are much lower compared to a more egalitarian society, which leads to lower per
capita income and income growth rate. However, concentrating assets and income in the
The hypothesis was not supported by his data set.