Working Paper: NBER ID: w13984
Authors: Jiandong Ju; Shangjin Wei
Abstract: Does finance follow the real economy, or the other way around? This paper unites the two competing schools of thought in a general equilibrium framework. Our key result is that there are threshold effects defined by a set of deep institutional parameters (cost of financial intermediation, quality of corporate governance, and level of property rights protection) which can be used to separate economies of high-quality institutions from those of low-quality institutions. On one hand, for economies with high-quality institutions, the view that finance follows the real economy is essentially correct. Equilibrium output and prices are determined by factor endowment. Further improvement in the institutions does not affect patterns of output. On the other hand, for economies with low-quality institutions, the view that finance is a key driver of the real economy is essentially correct. Not only is finance a source of comparative advantage, but an increase in capital endowment has no effect on outputs and prices. Our model extends a standard one-sector, partial equilibrium model of corporate finance to a multi-sector, general equilibrium analysis. Surprisingly, but consistent with data, we show that the size of financial markets (relative to GDP) does not change monotonically with either the quality of institutions or with the factor endowment. Free trade may reduce the aggregate income of an economy with low-quality institutions. Financial capital tends to flow from economies with low-quality institutions to those with high-quality institutions.
Keywords: Financial System; Comparative Advantage; Institutional Quality
JEL Codes: F1; F3; G3
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Quality of institutions (O43) | Economic outcomes (F69) |
| High-quality institutions (O43) | Finance follows the real economy (G29) |
| Low-quality institutions (O17) | Finance as a key driver of the real economy (G19) |
| Institutional quality (I24) | Capital mobility (F20) |
| Improvements in financial systems (O16) | Economic outputs (in high-quality institutions) (D29) |
| Infusion of capital (O16) | Equilibrium output (in low-quality institutions) (D59) |
| Free trade (F19) | Aggregate income (in low-quality institutions) (O17) |
| Financial capital flow (F21) | Institutional quality (I24) |