Project heterogeneity and growth: The impact of selection

The positive effect of higher credit availability on the volume of firm entry and thus output growth is a well documented relationship in the literature. Is this the only channel through which domestic funds affect entry? We use Chilean firm level data to show that the effect is indeed twofold: A lower level of domestic credit not only reduces the mass of new firms, but it also improves the average composition of the incoming cohort in terms of profitability. We build a Schumpeterian endogenous growth model with project heterogeneity and financial selection that nests both of these channels. The projects differ in their capacity to make drastic improvements on labor productivity, and good ideas are scarce. Enacting a project requires financing of start-up costs, hence the composition of an entrant cohort depends on the availability of credit. The financial system selects the projects to invest in; however, the accuracy with which they are able to select the projects that are more promising is not perfect and is determined by the financial development of the economy. We first characterize the behavior of the model along its unique balanced growth path. Static comparisons of different balanced growth paths show that the composition channel conciliates the mild reaction of growth to taxation together with more drastic changes in entry rates, a fact that the empirical literature put forward. We can also shed some light on the variation of the forgone growth across the OECD countries related to the rejection of loans to firms. Our model predicts that in financially more developed countries growth declines less in response to increases in loan rejection which is in line with the empirical observation. As a further step, we solve for the transition path which allows us to study the growth and welfare effects of several policy changes. Finally, we build a stochastic version of the model that is able to replicate the qualitative findings in the empirical section. We believe that this model provides a fruitful framework to further explore financial development in an endogenous growth setting.