Equilibrium Intermediation and Resource Allocation With a Frictional Credit Market

We model an economy where financial intermediation is subject to search frictions. The economy may reduce the extent of these frictions by devoting human resources to intermediation. More efficient credit markets (i.e., with less frictions) conduct to more efficient product markets via larger and more efficient firms. They are also conductive to a smaller size of the financial sector, as less resources need to be devoted to channeling funds between lenders and borrowers. Moreover, we show that the amount of resources devoted to intermediation along the growth path is unaffected by the relative abundance of capital. In contrast, improvements in the allocative efficiency in the product market produce a larger financial sector. In a Solow growth version of the model, more efficient credit markets are associated with higher steady state incomes and capital, more demanding selection of firms and, thus, more efficient aggregate production and more homogeneous firms. Outside steady state, the rate of growth for any given capital level is larger the more efficient the financial sector. In an AK version of the model, long run growth is decreasing in the amount of frictions in the credit market.