Working Paper: CEPR ID: DP4348
Authors: Jian Tong; Chenggang Xu
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; financial institutions; R&D; transition
JEL Codes: G00; K00; O10; O30; O40; P00
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| financial institutions (G21) | R&D project selection (O32) |
| R&D project selection (O32) | technological change (O33) |
| technological change (O33) | economic growth (O49) |
| financing regime M (G32) | higher steady-state development levels (O10) |
| legal institutions (D02) | choice of financial institutions (G20) |
| financing regime (G32) | growth dynamics (O41) |
| backward economy with centralized regime (P11) | rapid catch-up (O11) |
| inertia factor of an economy (E20) | growth momentum (O41) |
| financing regime M (G32) | stable growth patterns (O40) |
| choice of financing regime (G32) | institutional quality (L15) |
| choice of financing regime (G32) | development levels (I25) |