What's the correlation between inequality and economic stability?

Inequality can potentially undermine economic stability by fuelling social unrest and reducing aggregate demand.

Inequality refers to the uneven distribution of income and wealth within a society. High levels of inequality can lead to economic instability in several ways. Firstly, it can fuel social unrest and political instability. When a large portion of the population feels that they are not benefiting from economic growth, they may resort to protests or other forms of social unrest. This can disrupt economic activities and deter investment, leading to economic instability.

Secondly, high levels of inequality can reduce aggregate demand. The marginal propensity to consume (the proportion of additional income that a person spends) tends to be higher for lower-income individuals. Therefore, if a larger share of the national income goes to the wealthy, who have a lower marginal propensity to consume, overall consumption may decrease. This can lead to a slowdown in economic growth and potentially to economic instability.

Moreover, inequality can lead to inefficient allocation of resources. In a highly unequal society, the wealthy have a disproportionate influence on economic and political decisions. This can result in policies that favour the rich at the expense of the poor, leading to an inefficient allocation of resources. For example, the wealthy might lobby for tax breaks or subsidies that benefit them but are not in the best interest of the overall economy. This misallocation of resources can hinder economic growth and stability.

Lastly, high levels of inequality can also lead to financial instability. Research has shown that periods of high inequality often precede financial crises. One explanation for this is that in a highly unequal society, the poor may take on excessive debt in an attempt to maintain their living standards, leading to a build-up of financial risk.

However, it's important to note that the relationship between inequality and economic stability is complex and influenced by many factors. For instance, some level of inequality can provide incentives for individuals to work hard and innovate, potentially promoting economic growth. Therefore, the challenge for policymakers is to strike a balance between maintaining incentives for economic activity and preventing excessive inequality that could undermine economic stability.