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Equity markets, transaction costs, and capital accumulation

Listed author(s):
  • Bencivenga, Valerie R.
  • Smith, Bruce D.
  • Starr, Ross M.

There is a close, if imperfect, relationship between the effectiveness of an economy's capital markets and its level (or rate of growth) of real development. This may be because financial markets provide liquidity, promote the sharing of information, or permit agents to specialize. There is literature about how these functions help increase real activity, but surprisingly little literature predicting how the volume of activity in financial markets relates to the level or efficiency of an economy's productive activity. The authors address this question: how does the efficiency of an economy's equity market -- as measured by transaction costs -- affect its efficiency in producing physical capital and, through this channel, final goods and services? The answer: As the efficiency of an economy's capital markets increases (that is, as the transaction costs fall), the general effect is to cause agents to make longer-term -- hence, more transction-intensive -- investments. The result is a higher rate of return on savings and a change in its composition. These general equilibrium effects on the composition of savings cause agents to hold more of their wealth in the form of existing equity claims and to invest less in the initiation of new capital investments. As a result, a reduction in transaction costs can cause the capital stock either to rise or fall (under scenarios described in the paper). Further, a reduction in transaction costs will typically alter the composition of saving and investment, and any analysis of the consequences of such changes must take those effects into account.

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Paper provided by The World Bank in its series Policy Research Working Paper Series with number 1456.

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Date of creation: 31 May 1995
Handle: RePEc:wbk:wbrwps:1456
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  1. Valerie R. Bencivenga & Bruce D. Smith, 1991. "Financial Intermediation and Endogenous Growth," Review of Economic Studies, Oxford University Press, vol. 58(2), pages 195-209.
  2. Greenwood, Jeremy & Jovanovic, Boyan, 1990. "Financial Development, Growth, and the Distribution of Income," Journal of Political Economy, University of Chicago Press, vol. 98(5), pages 1076-1107, October.
  3. Robert G. King & Ross Levine, 1993. "Finance and Growth: Schumpeter Might Be Right," The Quarterly Journal of Economics, Oxford University Press, vol. 108(3), pages 717-737.
  4. Douglas W. Diamond, 1984. "Financial Intermediation and Delegated Monitoring," Review of Economic Studies, Oxford University Press, vol. 51(3), pages 393-414.
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