Credit cycles, human capital and the distribution of income

Abstract In this paper, we augment a model of endogenous credit cycles by Matsuyama et al. (2016) with human capital to study its impact on the stability of income evolution and its distribution. Human capital is modelled as pure external effect of production, following a learning-by-producing approach. Agents have access to two different investment projects, which differ substantially in their next generations spillover effects. Some generate pecuniary externalities and technological spillovers through human capital formation whereas others fail to do so. Moreover, the latter are subject to financial frictions. Together with the interaction between those projects, endogenous credit cycles occur and a pattern of boom and bust cycles can be observed. We explore the impact of human capital on the systems stability by providing analytical results and numerical simulations, which confirm a strong interaction between credit market frictions and the importance of human capital in the production process. In general, we found that an increasing importance of human capital has an ambiguous effect on the income evolution. Especially during transition periods, we observe a destabilising effect while with high human capital importance, the income path is stabilised. Moreover, an increase of the importance of human capital favours investment projects with positive intergenerational spillovers, thus driving up the labour income of the young generation. Thus, our study reveals that human capital is an essential factor for economic stability under the presence of financial frictions and has substantial positive effects on the income distribution.