Does income distribution matter for effective demand? Evidence from the United States

This article examines the influence of income distribution in the determination of effective demand in the US. A simple model is developed to simulate the effects of changing income inequality on the aggregate propensity to consume. The simulation results illustrate that income inequality has a substantial negative impact on consumption when household spending is assumed to be income‐constrained. Econometric evidence is presented that rising private sector wage inequality had a dampening effect on the time path of consumption in the United States between 1978 and 2000. The methodology entails time series estimation of consumption specifications with a measure of income inequality (the Theil index) included among the explanatory variables. The argument is made that, ceteris paribus, rising income inequality creates a need for greater reliance on debt to sustain a given level of household spending.