The Effect of External Finance on the Equilibrium Allocation of Capital

Abstract

We develop an equilibrium model to understand how the efficiency of capital allocation depends on outside investor protection and the external financing needs of firms. We show that when capital allocation is constrained by poor investor protection, an increase in firms' external financing needs may improve allocative efficiency by fostering the reallocation of capital from low to high productivity projects. We also find novel empirical support for this prediction.

Keywords: capital reallocation, financial development, investor protection, external finance

JEL Classification: G15, G31, D92