Financial Development and Economic Growth: New Lessons from Small Open Economies

This paper develops a political economy framework to explain the underlying financial mechanisms through which redistributive policies may affect both the relative level of per capita income growth rates, and the relative stability of growth paths across countries. It proposes that socio-politically motivated redistributive policies characterized by financial exclusion may undermine financial intermediation. By extension, it argues that politically unconnected productive firms may face binding financial constraints in normal times, and both politically connected and unconnected firms may jointly face binding financial constraints in abnormal times. This may give rise to an output gap in normal times that diverges in abnormal times. It is shown that this theoretical framework can explain growth disparities between Jamaica and Barbados since the 1960s. In addition, it offers new lessons on the importance of effective long-run pro-poor-pro-growth strategies for developing countries with acute income inequality.