Aggregate Demand Externalities, Income Distribution, and Wealth Inequality

By Luke Petach, Daniele Tavani

PKES Working Paper 2108

June 2021

We study a two-class model of growth and the distribution of income and wealth at the intersection of contemporary work in classical political economy and the post-Keynesian tradition. The key insight is that aggregate demand is an externality for individual firms: this generates a strategic complementarity in production that results in equilibrium under- utilization of the economy’s productive capacity and hysteresis in real GDP per-capita in balanced growth. This equilibrium inefficiency reverberates into both the functional dis- tribution of income and the distribution of wealth: both the wage share and the workers’ wealth share would be higher at full capacity. Consequently, fiscal allocation policy that achieves productive efficiency also attains a higher labor share and a more equitable dis- tribution of wealth. Demand shocks also have permanent level effects. Extensions look at temporary growth and employment effects of fiscal policy with dynamic increasing re- turns, and employment hysteresis. These findings are useful as an organizing framework for thinking through the lackluster economic record of the so-called Neoliberal era, the sluggish recovery of most advanced economies following the Great Recession, and what to expect regarding the recovery from the Covid-19 shock.

Keywords: Externalities, Capacity Utilization, Factor Shares, Wealth Inequality

JEL classification: D31 D33 D62 E12