Chapter 4 Financial Development in Endogenous Growth Models

1
Chapter 4Financial Development in Endogenous
Growth Models
2
In this chapter, we mainly study the second
generation financial growth model.

• None of them attempts to combine short-run
  stabilization with long run growth.
• All these financial development models using
  endogenous growth ignore the dynamic process of
  financial liberalization or stabilization.

3
Asymmetric Information and Uncertainty

• In principle, financial contracts could be
  written to deal with all future contingencies.
  Such a set of state-contingent securities is
  known as Arrow-Debreu securities.
• The Arrow-Debreu solution can exists only if
  information about all possible state of the world
  is freely available and easily interpretable
  monitoring must also be costless.

4
Effects of Financial Intermediaries on Portfolio
Choices

• Construct a model in which individuals can choose
  between unproductive assets and an investment in
  a firm.
• Here young individuals work only in the first
  period of their lives of a real wage and
  consume only in periods 2 and 3. All young
  individuals have utility function

5

• Type A individuals live three periods, while type
  B individuals live only two periods. At the
  beginning of age 2, individuals discover whether
  they are type A individuals.
• With introduction of banks, individuals can hold
  deposits which banks then invest in currency and
  capital.

6

• The banks maximization problem can be
  illustrated in the simplest case of logarithmic
  preferences (e0). In this case
• Now the banks maximization problem can be
  expressed
• Maximize
• subject to

7

• Neither type A nor type B individuals could do
  better by holding any combination of currency and
  capital rather than by holding deposits.
• Hence banks avoid the uncertainty which leads to
  resources misallocation by individuals. By
  ensuring that capital is never wasted, financial
  intermediation may produce higher capital/labor
  ratios and higher rates of economic growth.

8

• The existence of a stock market increases the
  growth rate in comparison to a situation with on
  financial intermediation. This is simply because
  stock markets can prevent premature capital
  liquidation by enabling individuals to sell firms
  that they will be unable to operate in period 3.
• However, when a stock market is compared to a
  banking system, relative growth rates depend on
  the degree of risk aversion.

9

• Pay attention to the transactions costs.
• First, if the cost is high enough, no one will
  use the stock market and the economy returns to
  financial autarky.
• Second, banks need fewer financial transactions
  than stock do.

10

• Reduced liquidity and productivity risks
  encourage individuals to invest more in firms. In
  various ways, therefore, financial institutions
  can encourage individuals to invest more
  resources, either directly or indirectly, in
  firms. More investment in firms raises the rate
  of economic growth.

11
Financial Development and Endogenous Growth

• The main feature of endogenous growth models is
  that a broadly defined concept of the economys
  capital stock does not suffer from diminishing
  returns. One approach is to broaden the concept
  of capital to include human capital or the state
  of knowledge.

12

• Another of the more unrealistic assumptions in
  the model is the absence of financial
  intermediation costs. Rectify this by introducing
  costly financial development into the endogenous
  growth mode
• Hence, financial development could affect growth
  by influencing A, s, or µ.

13

• King and Levine (1993b) provide an alternative
  way of including finance in endogenous growth
  models by separating the economy into households,
  financial institutions, and firms.
• Overall, the evaluation and sorting of
  entrepreneurs lowers the cost of investing in
  productivity enhancement and stimulates economic
  growth.

14
Real Interest Rate
Ramsey Curve
rl r rd
W
Romer Curves
Growth Rate
15

• In all these models, growth rate comparisons can
  be made between economies with and without banks.
  Relative to the situation in the absence of
  banks, banks reduce liquid reserve holdings by
  the economy as a whole, and also reduce the
  liquidation of productive capital. Then, with an
  externality in productionhigher equilibrium
  growth rates with observed in economies with an
  active intermediary sector

16
Financial Repression in Endogenous Growth Models

• Financial repression reduces the service provided
  by the financial system to savers, entrepreneurs,
  and producers it thereby impedes innovative
  activity and slows economic growth.

17
Examples for financial repression

• The higher cost of evaluating and financing
  entrepreneurs
• Financial sector taxes
• Imposition of credit ceilings
• Government interventions such as an increase in
  corporate profits tax or weakened property rights
• Inflation

18
Emergence and Development of Financial Structures

• There are various rationales for the existence of
  financial institutions, such as, some for of
  uncertainty, costly information, transaction
  costs, and economies of scale in information
  collection.
• Why financial intermediation emerge during the
  process of economic development?

19

• Because there are fixed entry costs to
  individuals who wishes to use financial
  intermediaries, individuals use them only after
  their incomes and wealth reach some minimum
  level. Hence, in the early stages of economic
  development there are virtually no financial
  institutions.

20
Summary

• In contrast to the McKinnon-Shaw models, the
  endogenous growth models surveyed in this chapter
  provider a rationale for financial intermediation
  and explain how financial intermediaries emerge.
• Financial systems can encourage holdings
  individuals to release their savings for
  productive investment and can also improve the
  allocation of investible funds.