Financial constraints and economic development: the role of innovative investment

This paper argues that accounting for firms' endogenous productivity growth plays an important role in understanding the link between financial and economic development. First, using a simple analytically tractable model, it shows that incorporating endogenous investment in firm productivity into the model amplifies the negative impact of borrowing constraints on output. This occurs even if the models with and without such productivity investments are calibrated to match the same value of profit to output ratio in the absence of borrowing constraints. Second, the paper embeds productivity investment into an otherwise standard variation of the Bewley-Aiyagary-Hugget model used in the existing literature to evaluate the impact of borrowing constraints on economic development. Preliminary numerical results suggest that the borrowing constraints have a considerably larger impact in the model with endogenous innovative investment, compared to the model in which the firm productivity grows exogenously (and is calibrated to match the same moments in the unconstrained benchmark). For example, under a conservative calibration in which the ratio of intangible investment to output is 5.5%, the GDP and measured TFP fall by 37% and 12.5%, respectively. In contrast, in an observationally equivalent model, in which the firm productivity follows an exogenous random process, the GDP and measured TFP fall by only 28% and 4.6%, respectively.