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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.

Suggested Citation

  • Tong, Jian & Xu, Cheng-Gang, 2004. "Financial Institutions and the Wealth of Nations: Tales of Development," CEPR Discussion Papers 4348, C.E.P.R. Discussion Papers.
  • Handle: RePEc:cpr:ceprdp:4348
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    More about this item

    Keywords

    development; financial institutions; R&D; transition;
    All these keywords.

    JEL classification:

    • O10 - Economic Development, Innovation, Technological Change, and Growth - - Economic Development - - - General
    • O30 - Economic Development, Innovation, Technological Change, and Growth - - Innovation; Research and Development; Technological Change; Intellectual Property Rights - - - General
    • O40 - Economic Development, Innovation, Technological Change, and Growth - - Economic Growth and Aggregate Productivity - - - General
    • P00 - Economic Systems - - General - - - General

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