Imperfectly Substitutable Financial Instruments in an Economic Development Model

The ideas put forth in this article are related to the literature on economic growth and development, on one side, and that of the development of financial systems on the other. A simple two-sector model is proposed. In that model, one sector groups activities that are typically present in a developed economy, and the other, those that can usually be associated to a developing economy. Among the things that are required for a country to transition to a specialization on the first group of activities, which is what many developing nations are actively seeking, the model highlights the role of the financial system. In the model, the development of the financial system is primarily indicated by an increase on the variety of financial instruments. As a country develops, it can provide its productive sector with more financial instruments that allow for a more sophisticated production of goods and services. Under certain conditions, the model exhibits multiple equilibrium. The two real sectors in this economy have different production functions. The financial systems comprises two types of actors: (1) individual producers of financial services, and (2) a financial aggregator that produces a synthetic financial instrument combining them. By blending together financial instruments there is a positive effect on the real sector, tantamount to an increase in productivity. The article explores the interaction of real and financial sectors in a developing economy. Many of the problems and bottlenecks found by the development economics school of thought are present here, notably it is shown how hard it could be for a country to transit from low to high stages of development. Pervasive market failures and externalities that have roots in production, and financial asymmetries partly explain that situation. In what comes to the relation between real and financial sectors in the model, there is a two-way external effect (so they affect each other the way externalities do). Economic actors have short term planning horizon when externalities are present. In particular, everyone involved in the production sector (firms and workers) take the variety of financial instruments currently existing at the time they plan their actions as a fact, and they cannot anticipate what that variety (and the more advanced production techniques that that brings along) is going to be in the future. The set up has two main consequences: (1) real and financial sectors tend to evolve together, and rather slowly, and (2) there is scope for government intervention. The model is solved numerically, and it is sound in the sense that it accurately reflects certain stylized factors of real-life economic development processes (related to the development of the financial system vis à vis the real productive sector, the pace of economic growth, and the type of financial development). Also, the model shows (by way of comparative static and numeric simulations) that an improvement in the parameters of the financial system has a positive effect on the economy in the long run. As stated before, it is not implied by the model that an economy that is stuck in a low-income situation will automatically leave that situation behind by means of an autonomous development of its financial or productive systems. Political recommendations implied by this simple model pertain both to the financial and real sectors. In particular, the government could provide directly or indirectly for a wider variety of financial instruments that may have positive impact on the quality and quantity of aggregate production in the economy. These include provision of “missing” financial services in the way development and public banks could do, or introducing specific legislation that will make private suppliers of financial instruments do so. Furthermore, as the development of real and financial sectors goes hand in hand, actions on the real sector (improving dissemination of technical and scientific knowledge, training specific sectors of the population into productive skills, for example) also have an effect on the sustainability of financial reform and the long term availability of the enlarged array of financial instruments. Several countries have successfully tackled this issues, and implemented bills and regulations that improved their economies on both financial and real grounds. Some have gone the way of grandeur (Brazil comes to mind) and others have done so through dedicated and specific interventions that blend “real” and financial ingredients (examples can be found in Chile and Guatemala).