Optimal Financing Contracts, Investor Protection, and Growth
Recent empirical evidence has suggested a positive association between various measures of investor protection and financial market development, and between financial market development and economic growth. We introduce investor protection in a simple extension of the two-period overlapping generations model of capital accumulation. We use such structure in order to develop predictions for the effects of investor protection on economic growth. Young individuals (entrepreneurs) are endowed with investment projects that need to be financed by outside investors. The quality of each project is random and unknown at the time of financing. Ex-post, once production is carried out, entrepreneurs observe their cash-flows, but financiers do not. Thus agents have an incentive to misreport their cash-flows and appropriate part of them. We capture the degree of investor protection as the extent to which this appropriation is possible. For a closed economy, our results show that, contrary to conventional wisdom, better investor protection is generally detrimental to capital accumulation and economic growth. The standard argument says that if investors are risk-averse, better investor protection results in larger demand for capital. In addition to this effect, we show that the aggregate supply of capital decreases with better investor protection, and we find that this second effect generally dominates the first. With international capital mobility, instead, better investor protection does promote financial market development and output growth. The key mechanism is an increase in the net inflow of capital from abroad, suggesting a specific channel through which investor protection affects the economy.
|Date of creation:|
|Date of revision:|
|Contact details of provider:|| Postal: Tepper School of Business, Carnegie Mellon University, 5000 Forbes Avenue, Pittsburgh, PA 15213-3890|
Web page: http://www.tepper.cmu.edu/
|Order Information:||Web: http://student-3k.tepper.cmu.edu/gsiadoc/GSIA_WP.asp|
When requesting a correction, please mention this item's handle: RePEc:cmu:gsiawp:-1709258802. See general information about how to correct material in RePEc.
For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Steve Spear)
If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.
If references are entirely missing, you can add them using this form.
If the full references list an item that is present in RePEc, but the system did not link to it, you can help with this form.
If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your profile, as there may be some citations waiting for confirmation.
Please note that corrections may take a couple of weeks to filter through the various RePEc services.