Capital Openness and Income Inequality: Smooth Sailing or Troubled Waters?

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May 2017
The 2008 Financial Crisis and subsequent financial turbulence has triggered economists and policymakers to revisit the extent to which capital account liberalization is optimal for all countries at all levels of development. While that literature has largely concluded that capital account liberalization may have detrimental effects on growth and accentuate financial instability in emerging markets, relatively little literature has examined the impacts of capital account liberalization on inequality—a subject that has also been under intense study over the past decade as well. In this paper, we attempt to build upon and bridge these two literatures to examine the extent to which capital account liberalization is associated with income inequality. We confirm earlier studies that show there is such a relationship between increased capital account openness and increases in inequality, and that capital account regulations are associated with less inequality—at least for emerging market economies. We expand on these findings to learn that there are differential impacts of capital account liberalization on inequality during booms and busts, being financial development a key factor. During normal times, we find that there are positive impacts on income inequality, whereas during busts, capital account liberalization appears to exacerbate inequality, calling for active policies.