Financial Development And Instability:The Role Of The Labour Share
This paper examines the role of the labour share in creating instability in a small open economy. We assume that ﬁnancial markets are imperfect so that entrepreneurs are credit constrained, and that this constraint is tighter for low levels of ﬁnancial development. Aghion, Bacchetta and Banerjee (2004) have shown that as the degree of ﬁnancial development increases, output rises but instability appears for intermediate levels of ﬁnancial development. Crucially, they assume that labour is paid before production takes place, and hence crises are solely due to the increased cost of debt repayment as ﬁrms accumulate capital. We show that under the more reasonable assumption that wages are paid at the end of the period, changes in the labour share also play a role in eroding proﬁtability. Our analysis also predicts that ﬁnancial crises are associated with substantial movements in the sharing of value added between capital and labour.
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