Financing Development: The Role of Information Costs

University Of Pennsylvania, Philadelphia PA

Investigators

Abstract

Why are some countries richer or poorer than other ones? The research funded in this award examines the contribution that financial markets make to economic development. Economists have long been interested in the answer to the question: Why should financial markets matter? The hypothesis advanced is that financial markets promote economic development by channeling investment funds to the places in an economy that will yield the highest returns. This will spur economic growth, and hence economic development. To address this question an economic model of financial intermediation will be developed. The model will emphasize the role that financial intermediaries play in producing information about investment opportunities. There are two types of information production: ex ante and ex post. Intermediaries play a crucial role in discovering important new investment opportunities. This is an example of ex ante information production. They also play a crucial role in ensuring that borrowers use investment funds in a judicious and honest manner. They may do this by auditing projects. This is an example of ex post information production. Information production is a costly activity, and some countries do it more efficiently than others. Countries have vast differences in the sophistication of their financial markets. Investors may be reluctant to invest in poorer countries because of fears that their funds will not be used appropriately due to a lack of investor protections, such as the ability to monitor projects adequately. Countries that have efficient financial markets should see more investment relative to countries that don't. The efficiency of financial markets will therefore be reflected in a country's capital-to-output ratio. This ratio speaks to how much of a country's output is produced by capital versus other means of production, such as labor. Intriguingly, rich countries have higher capital-output ratios than do poor ones. Additionally, efficient financial markets will have low interest-rate spreads between what firms pay on loans and savers earn on their savings. This spread reflects the costs of producing information, as well as other costs of financial intermediation. Again, interestingly, poor countries have larger interest-rate spreads than do rich countries. There are tremendous differentials in countries' income levels. For example, per capita income in the U.S. is 11 times higher than per capita income in India. Exactly how much of this large differential in per capita income is due to poor financial markets in India, and how much is due to other factors, say, import restrictions, and lack of anti-trust regulations? A goal of the analysis will be to provide an explicit answer to this question. This will be done by simulating on a computer the economic model developed for a sample of countries in the world. This simulation will be undertaken in a manner such that the economic model developed matches the distribution of output, capital-output ratios, and interest-rate spreads observed in the world economy. It will then be possible to uncover how of much of the differences in countries' incomes are due to financial markets. The answer to this question will have important policy implications. If a lack of a financial development is a significant hindrance to economic development, then policies that promote more effective financial intermediation may have a high degree of efficacy in improving the lot of poor countries. Such a finding would have broad impact.