Household Debt and Income Inequality, 1963–2003

I construct an economy with heterogeneous agents that mimics the time‐series behavior of the earnings distribution in the United States from 1963 to 2003. Agents face aggregate and idiosyncratic shocks and accumulate real and financial assets. I estimate the shocks that drive the model using data on income inequality, aggregate income, and measures of financial liberalization. I show how the model economy can replicate two empirical facts: the trend and cyclical behavior of household debt and the diverging patterns in consumption and wealth inequality over time. While business cycle fluctuations can account for the short‐run changes in household debt, its prolonged rise of the 1980s and the 1990s can be quantitatively explained only by the concurrent increase in income inequality.