This paper examines the two-way relationship between inequality and economic fluctuations, and the implications for human development. For years, the dominant paradigm in macroeconomics, which assumed that income distribution did not matter, at least for macroeconomic behavior, ignored inequality—both its role in causing crises and the effect of fluctuations in general, and crises in particular, on inequality. But the most recent financial crisis has shown the errors in this thinking, and these views are finally beginning to be questioned. Economists who had looked at the average equity of a homeowner—ignoring the distribution—felt comfortable that the economy could easily withstand a large fall in housing prices. When such a fall occurred, however, it had disastrous effects, because a large fraction of homeowners owed more on their homes than the value of the home, leading to waves of foreclosure and economic stress. Policy-makers and economists alike have begun to take note: inequality can contribute to volatility and the creation of crises, and volatility can contribute to inequality. Here, we explore the variety of channels through which inequality affects fluctuations and fluctuations affect inequality, and explore how some of the changes in our economy may have contributed to increased inequality and volatility both directly and indirectly. After describing the two-way relationship, the paper discusses hysteresis—the fact that the consequences of an economic downturn can be long-lived. Then, it examines how policy can either mitigate or exacerbate the inequality consequences of economic downturns, and shows how well-intentioned policies can sometimes be counterproductive. Finally, it links these issues to human development, especially in developing countries.
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