Financial Institutions and the Wealth of Nations: Tales of Development

56 Pages Posted: 19 May 2004  

Jian Tong

University of Southampton - Division of Economics

Chenggang Xu

University of Hong Kong

Multiple version iconThere are 2 versions of this paper

Date Written: April 2004

Abstract

Interactions between economic development and financial development are studied by looking at the roles of financial institutions in selecting R&D projects (including both imitation and innovation). Financial development is regarded as the evolution of the financing regimes. The effectiveness of R&D selection mechanisms depends on the institutions and the development stages of an economy. At higher development stages, a financing regime with ex post selection capacity is more effective for innovation. This regime, however, requires more decentralized decision-making, which in turn depends on contract enforcement. A financing regime with more centralized decision-making is less affected by contract enforcement but has no ex post selection capacity. Depending on the legal institutions, economies in equilibrium choose regimes that lead to different steady-state development levels. The financing regime of an economy also affects development dynamics through a 'convergence effect' and a 'growth inertia effect.' A backward economy with a financing regime with centralized decision-making may catch up rapidly when the convergence effect and the growth inertia effect are in the same direction. This regime leads to large development cycles at later development stages, however. Empirical implications are discussed.

Keywords: Development, transition, financial institutions, R&D

JEL Classification: O10, O30, O40, P00

Suggested Citation

Tong, Jian and Xu, Chenggang, Financial Institutions and the Wealth of Nations: Tales of Development (April 2004). CEPR Discussion Paper No. 4348. Available at SSRN: https://ssrn.com/abstract=547763

Jian Tong

University of Southampton - Division of Economics ( email )

Southampton, SO17 1BJ
United Kingdom
(44 23) 8059 6801 (Phone)
(44 23) 8059 3858 (Fax)

Chenggang Xu (Contact Author)

University of Hong Kong ( email )

Pokfulam Road
Hong Kong, Pokfulam HK
China

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