In a handbook devoted to income distribution, a chapter devoted to macroeconomics should start by clarifying the role of macroeconomics.

Two of the main concerns about macroeconomics are aggregation and general equilibrium. The first ensures that the var­ious sections of the economy aggregate, that is, by adding the incomes, wealth, and other variables of all households, we obtain the economywide value of these variables.

Since Bertola (2000) (the macroeconomics chapter in Volume 1 of this handbook series), many changes have taken place in the way macroeconomists deal with income inequality. One important change is that interest has shifted away from the study of the relation between inequality and long-term growth and has focused more on other aspects of macroeconomic performance. Perhaps the main reason for this change is that, in general, there is less concern about long-term growth. Now, the more popular view is that all advanced economies grow by about 2% annually. The main question is, what does it take for less-developed countries to accelerate the process of development and join the group of rich countries? As a result of these changes, macroeconomists have two main concerns with regard to inequality. One is what determines the joint distribution of earnings (or labor income) and wealth, and the other is how the explicit account of empirically sound inequality shapes the answers to the standard questions in macro­economics.

The outline of the chapter is as follows. We start in Section 14.1 with some facts on the U.S. income and wealth distribution that are relevant from a macroeconomic point of view. We look at both cross-sectional evidence and the changes observed in the last few decades. Although some of these facts are analyzed in more detail in other chapters of this handbook (for example, Chapters 7-9), it will be useful to summarize them here as they are the reference for some of the theories we will review in this chapter.

After summarizing the main empirical facts about the income and wealth distribution, we take a look in Section 14.2 at how macroeconomists make sense of these facts. First, we show how the distribution of wealth is determined given an exogenous process for earnings. After reviewing the models used by macroeconomists to examine this question and their success in replicating the wealth distribution observed in the data, we turn to models of endogenous determination of earnings. We look at models of human capital investment to determine why some people are more successful than others, in the sense of earning higher labor incomes. Thus, we will look at earnings inequality not as a purely stochastic process (luck) but as an outcome of different mechanisms such as investment in human capital (for example, education) or the higher relative demand of certain skills (affecting the relative prices of certain skills compared with other skills).

Next we turn to the dynamics of inequality. Section 14.3 studies how inequality may change both over the business cycle and over a longer horizon. Here we consider a simple model in which factor shares—of capital and labor—can change.

Section 14.4 deals with what is possibly one of the most exciting ways in which mac­roeconomics and inequality interact: the role of financial markets or, more specifically, financial frictions. We start by looking at how the ability to borrow shapes the income and wealth distribution (and the allocation efficiency) by reallocating investment funds to entrepreneurs that are efficient and reliable, but not always both. We then turn to how wealth inequality is shaped by borrowing ability even when the rate of return of savings is equated across households. First, we look at how the sheer ability to borrow shapes inequality, and then we consider endogenous theories of borrowing where financial fric­tions arise from the institutional environment. We also look at various extensions of these ideas where the frictions are endogenous. In addition to exploring the effects of financial frictions on inequality, we look at the long-term effects on the performance of the econ­omy, including some issues that have become of concern to macroeconomists, such as implications for global imbalances.

In Section 14.5 we analyze how the political system interacts with inequality to yield different policies that have an impact on the aggregate performance of the economy. Peo­ple have different views about the desirability of alternative economic policies that depend on the position of individuals in the economywide distribution of income.

Section 14.6 concludes the chapter with a global assessment of what may be behind some of the changes observed in the last few decades.

Finally, a note of caution and a disclaimer. Throughout the chapter, we make use of various theoretical models that, for expositional purposes, are kept simple. Although this makes the intuitions of the basic mechanisms easy to understand, it also implies that these models may not be completely suited to address quantitative questions. Therefore, even if we often illustrate the properties of the model quantitatively, we should be careful in interpreting the simulation numbers as they are often intended to provide a qualitative, rather than quantitative, assessment of the model. The disclaimer is about the necessary incompleteness of this chapter. As much as we have tried to provide a general presenta­tion of the studies that deal with inequality in macroeconomics, covering all possible sub­jects is impossible. There are many topics that we do not review. For example, we exclude studies that introduce behavioral elements in macroeconomic analysis. In part, this is motivated by our limited expertise in these subjects. We have also avoided for the most part the study of inequality in developing countries. We have marginally touched on issues such as the impact of the rise in inequality on the U.S. economy, the macro­economic causes for the rising inequality, and globalization and inequality among others. Perhaps, more importantly, we have only scratched the surface of how income inequality translates into consumption inequality, which is what most economists think is what really matters. The topic of income inequality is quite vast, and different authors would write it quite differently; in fact, Thomas Piketty’s chapter in this volume includes some macro modeling of the wealth distribution with a very different flavor than this chapter.

14.1.