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Financial Institutions and the Wealth of Nations: Tales of Development

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  • Tong, Jian
  • Xu, Cheng-Gang

Abstract

Interactions between economic development and financial development are studied by looking at the roles of financial institutions in selecting R&D projects (including both imitation and innovation). Financial development is regarded as the evolution of the financing regimes. The effectiveness of R&D selection mechanisms depends on the institutions and the development stages of an economy. At higher development stages a financing regime with ex post selection capacity is more effective for innovation. This regime, however, requires more decentralized decision-making, which in turn depends on contract enforcement. A financing regime with more centralized decision-making is less affected by contract enforcement but has no ex post selection capacity. Depending on the legal institutions, economies in equilibrium choose regimes that lead to different steady-state development levels. The financing regime of an economy also affects development dynamics through a ‘convergence effect’ and a ‘growth inertia effect.’ A backward economy with a financing regime with centralized decision-making may catch up rapidly when the convergence effect and the growth inertia effect are in the same direction. This regime leads to large development cycles at later development stages, however. Empirical implications are discussed.

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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 4348.

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Date of creation: Apr 2004
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Handle: RePEc:cpr:ceprdp:4348

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Keywords: development; financial institutions; R&D; transition;

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Cited by:
  1. Veysov, Alexander & Stolbov, Mikhail, 2011. "The impact of financial sector on innovation activity: theoretical background and new evidence from russian banking sector," MPRA Paper 38747, University Library of Munich, Germany.
  2. Daron Acemoglu & Philippe Aghion & Fabrizio Zilibotti, 2006. "Distance to Frontier, Selection, and Economic Growth," Journal of the European Economic Association, MIT Press, vol. 4(1), pages 37-74, 03.

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