From Inequality to Growth: The Role of Knowledge Creation

In this paper, I revisit the classic question: how does inequality affect growth? I propose a new channel- knowledge creation- through which the relationship between growth and inequality could be affected. In the model, knowledge is created within firms through the interaction of agents with dif-ferent abilities. An increase in inequality of the underlying distribution of abilities affects knowledge creation by changing how agents match within firms. I uncover two effects that determine how aggre-gate knowledge creation and consequently, the growth rate changes. A change in inequality increases the average ability of agents creating knowledge- the distribution effect. At the same time, there are fewer agents engaged in knowledge creation- the allocation effect. I examine the conditions under which one effect dominates the other. Using the model, I provide one possible explanation for Barro’s (1993) finding that inequality reduces growth rate for less developed countries but increases the rate for developed countries