Inequality, openness, and growth through creative destruction

We examine how inequality and openness interact in shaping the long-run growth prospects of developing countries. To this end, we develop a Schumpeterian growth model with heterogeneous households and non-homothetic preferences for quality. We show that inequality affects growth very differently in an open economy as opposed to a closed economy: If the economy is close to the technological frontier, the positive demand effect of inequality on growth found in closed-economy models may be amplified by international competition. In countries with a larger distance to the technology frontier, however, rich households satisfy their demand for high quality via importing, and the effect of inequality on growth is smaller than in a closed economy and may even be negative. In such case trade gives rise to the endogenous emergence of a ‘dual economy’ where some domestic sectors are highly innovative while others are lagging behind. •The growth effects of inequality depend critically on a country's openness to trade.•Higher inequality increases incomes of the rich and their demand for innovation.•In closed economies, inequality is thus beneficial for innovation and growth.•In open developing countries, inequality increases imports and harms growth.•Foreign competition results in the endogenous emergence of a dual economy.