Working Paper

A New Perspective on the Finance-Development Nexus

Abstract: The existing literature on financial development focuses mostly on the causal impact of the quantity of financial intermediation on economic development. This paper, instead, focuses on the role of the financial sector in creating securities that cater to the needs of heterogeneous investors. To that end, we describe a dynamic extension of Allen and Gale (1989)?s optimal security design model in which producers can tranche the stochastic cash flows they generate at a cost. Lower tranching costs in that environment lead to capital deepening and raise aggregate output. The implications of lower tranching costs for TFP, on the other hand, are fundamentally ambiguous. In other words, our model predicts that increased financial sophistication/complexity?a securitization boom, e.g.?can have adverse consequences on aggregate productivity as it is conventionally measured.

Keywords: Endogenous security markets; financial development; economic development; ;

JEL Classification: E30; E44;

Bibliographic Information

Provider: Federal Reserve Bank of Cleveland

Part of Series: Working Papers (Old Series)

Publication Date: 2017-06-13

Number: 1629

Pages: 31 pages