Educational Signaling, Credit Constraints and Inequality Dynamics

We present a dynamic OLG model of educational signaling and inequality with missing credit markets. Agents are characterized by two sources of unobserved heterogeneity: ability and parental income, consistent with empirical evidence on returns to schooling. Both quantity and quality of human capital evolve endogenously. The model generates a Kuznets inverted-U pattern in skill premia similar to historical US and UK experience. In the first (resp. later) phase the skill premium rises (falls), social returns to education exceed (falls below) private returns: under-investment owing to financial imperfections dominate (are dominated by) over-investment owing to signaling distortions. There always exist Pareto-improving policy interventions reallocating education between poor and rich children. University of Salerno and Boston University, respectively. Mookherjee’s research has been supported by NSF Grant no. SES-0617874. We are grateful to Bob Margo for familiarizing us with the historical literature on skill premia in the US and in the UK.