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Financial Institutions And The Wealth Of Nations

All successful development in history has involved intertwined institutional and technological changes, which is always associated with an economy catching up to the more developed economies in terms of wealth and technology. For example, Japan after the Meiji Restoration and after World War II and European economies in the 19th century have observed that the banking system in continental Europe played a role in catching up. Schumpeter (1936) argued that banks played a role in selecting projects that ultimately affected the technological and economic development.

In this paper, the focus is on financial institutions where a growth model with financing mechanisms, development levels, R & D activities, and economic growth are endogenized jointly. R &D has all activities improving knowledge about technology. Legal conditions and development level given affect the choice of financial institution, which in turn determine the R&D selection mechanism and efficiency. This results to economies developing along different paths.

In the model, the impact of project selection mechanism associates with different financial institutions on development as it relates to the incentives given to them by the Institutions. The incentives are important because they deal with the following R&D features: • Uncertainty of R&D projects for innovation can be high such that project knowledge is known ex post. • Lack of resources to finance projects. • Having informational advantage over projects that they work with, entrepreneurs cheat on the project worth. Cheating can be deterred by a better R&D selection mechanism for innovation and ex post punishment.

We study two types of institutions: regime S with a more centralized decision making and who have no commitment for ex post punishment as they are associated with a soft budget constraint (SBC) and regime M with a decentralized decision making and are committed to punishment as they associate to hard budget constraints. Regime M is also efficient in innovation while regime S is efficient in technology. A convergence is predicted such that in equilibrium, economies with strong legal institution choose M that leads to high development level and those with weal legal institutions choose S.

The catch up dynamics is also analyzed here by decomposing the impacts of institutions o the development dynamics into a ‘convergence effect’ and a ‘growth inertia effect’, which is a measure of the ability to reserve momentum of growth performance. The inertia factor is affected by how much ex ante R&D selection is used in the economy and is smaller in regime M than regime S. Regime S catches up faster with economy in its earlier development stage but falls around low steady state development levels unlike regime M which has higher steady state development but its speed of catching up depends on the legal insti

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