Intermediation costs, investor protection and economic development

Abstract

This paper studies the effect of financial repression and contract enforcement on entrepreneurship and economic development. We construct and solve a general equilibrium model with heterogeneous agents, occupational choice and two financial frictions: intermediation costs and financial contract enforcement. Occupational choice and firm size are determined endogenously, and depend on agent type (wealth and ability) and credit market frictions. The model shows that differences across countries in intermediation costs and enforcement generate differences in occupational choice, firm size, credit, output and inequality. Counterfactual experiments are performed for Latin American, European, transition and high growth Asian countries. We use empirical estimates of each country's financial frictions, and United States values for all other parameters. The results allow us to isolate the quantitative effect of these financial frictions in explaining the performance gap between each country and the United States. The results depend critically on whether a general equilibrium factor price effect is operative.