Dynamic Status Effects, Savings, and Income Inequality

This paper advances the hypothesis that the intensity of status preferences depends negatively on the average wealth of society (endogenous dynamic status effect), in accordance with empirical evidence. Our theory replicates the contradictory historical facts of an increasing saving rate along with declining returns to capital over time. By affecting the dynamics of the saving rate, the dynamic status effect raises inequality, thereby providing a behavioural mechanism for the observed diverse dynamics of income inequality across countries. In countries in which the dynamic status effect is strong (weak) inequality rises (declines) over time in response to a positive productivity shock.