Financial system and economic growth

Saturday, 5 April 2014: 4:00 PM
Moisa Altar, Ph.D , Research, Romanian-American University, Bucharest, Romania
Judita Samuel, Ph.D. , Romanian-American University, Bucharest, Romania
Adam Altar-Samuel, Ph., D, Student , Department of Computer Science for Business Management, Romanian-American University, Bucharest, Romania
A well-functioning financial system is critical for economic growth. A large and by now well established literature has shown the critical importance of the financial system for economic growth. Theory suggests that effective financial

institutions and markets that help overcome market frictions introduced by information asymmetries and transaction costs can foster economic growth through several channels.

We analyze a standard growth model with financial frictions. We consider a one sector small open economy populated by two types of agents: workers and entrepreneurs. We consider a continuum of heterogeneous entrepreneurs and a continuum of homogeneous workers.

We set up the economy in continuous time with infinite horizon and no aggregate shocks to focus on the properties of the transition paths.

In the framework of the model, financial development improves long-time economic growth through three channels: increasing the marginal productivity of generalized capital, raising saving rate and efficiently converting savings to investment. The mechanisms of the first channel imply that financial development will make more finance support available to the efficient projects confronted with liquidity constraints, financial markets diversify risk and encourage enterprises to make use of more professional technology, and financial intermediations make capital flow into the projects with high social return. In the model, heterogeneous entrepreneurs face borrowing constraints which result in a misallocation of capital and reduced labor productivity. In the short-run, the optimal policy intervention of government by means of taxes and subsidies increases labor supply, resulting in higher entrepreneurial profits and faster accumulation of entrepreneurial wealth. The model generates endogenous dynamics of total factor productivity (TFP), and  financial frictions represent the transmission mechanism  for news shocks to drive aggregate TFP fluctuation.

Key words: economic growth,  financial frictions,  optimal policy,  transition paths