The Long and Short of Financial Development
Abstract
Financial development helps a producer raise capital to fund long term complexinvestments. Consequently, it should increase output and welfare. However, our analysis
suggests this is not always so. We consider a simple economy where producers
and consuming/financing households are distinct agents, where producers lack sufficient
capital, and where households care about both pledgeable returns and liquidity.
In this economy, the producer’s greater ability to pledge long-term project earnings to
financiers can reduce long term production and welfare, even though it makes financing
more accessible. Our results have implications for why economies face impediments to
financial development and overall growth, especially when producer capital is scarce.
The competitive equilibrium is constrained efficient only when producer capital is low
and pledgeability constraints lead more productive assets to offer lower pledegable
returns than less productive assets.