Inequality and finance: The role of economic literacy

Abstract

The finance-inequality nexus is central to understanding cross-country income disparities, yet the evidence on whether financial development raises or lowers inequality remains mixed. This paper asks whether economic literacy, a population’s capacity to understand and use financial services, conditions that relationship. Using a panel of forty-eight countries over the 1995–2008 period and System GMM estimation that addresses the endogeneity of financial development, we find that financial development is positively associated with income inequality, but that this effect is significantly mitigated where economic literacy is higher. At low levels of economic literacy, financial development increases inequality; as literacy rises, the effect weakens, and at sufficiently high levels, it may become negligible. The moderating effect is negative and significant under two independently constructed measures of economic literacy: a survey-based index and an objective metric. It therefore does not depend on how literacy is measured. The result also holds under an alternative measure of financial development, a reduced instrument set, and controls for institutional quality. The findings identify economic literacy as a complement to financial development through which the distributional gains from finance can be more widely shared.