For narrower income inequality: traditional finance or microfinance?

Abstract

This paper uses the theory of information imperfections to examine the relationship between income inequality and financial development in a dual financial system comprising traditional finance and microfinance. It uses panel data for 97 developing countries over a period characterized by declining income inequality from 2000 to 2017. Traditional finance is measured through domestic credit relative to GDP and the IMF Financial Development Index. Microfinance is measured through the size of microfinance gross loan portfolio relative to GDP and the number of active microfinance borrowers to the total population. Controlling for various measures of macroeconomic and socioeconomic variables and using different econometric specifications including a random-effects linear regression model with endogenous sample selection, the results show that microfinance consistently predicts a lower income inequality measured by the Gini coefficient, while traditional finance shows no impact. The findings of this paper draw clear policy implications regarding the role of microfinance as a tool for income equality in developing countries.