Increasing Returns, Long-Run Growth and Financial Intermediation

This paper identifies a novel connection between the banking sector and economic growth. I consider strategic competition among banks in an economic growth model with externalities. The allocation delivered by the banking sector is proven to be different from that in the Walrasian equilibrium and Pareto superior to it in most cases. This result challenges prevailing views in three literatures. The banking literature has always assumed some frictions in the economy so that banks can survive. Here I show that such assumptions are not necessary for the existence of banks. The literature on strategic intermediaries argues that the equilibrium achieves the Walrasian equilibrium at best. Here I show that the equilibrium delivered by strategic competition among banks often achieves an allocation that is Pareto superior to the Walrasian equilibrium. Finally, the literature of new growth theories with externalities has been concerned with lack of incentives for nonrival goods and inefficiency of the decentralized equilibrium. In some cases, authors have had to assume monopolistic competition in order to sustain economic growth. This paper shows that a decentralized, competitive economy can pay rewards for nonrival goods. In particular, it achieves the Pareto optimal allocation in the widely used case where the production function exhibits the constant returns to the accumulated capital.