nep-fdg New Economics Papers
on Financial Development and Growth
Issue of 2006‒12‒01
four papers chosen by
Iulia Igescu
Global Insight, GmbH

  1. How Does Foreign Direct Investment Promote Economic Growth? Exploring the Effects of Financial Markets on Linkages By Laura Alfaro; Areendam Chanda; Sebnem Kalemli-Ozcan; Selin Sayek
  2. Banks, Liquidity Crises and Economic Growth By Alejandro Gaytan; Romain Ranciere
  4. Equity Markets and Economic Development: What Do We Know By Thomas Lagoarde-Segot; Brian M. Lucey

  1. By: Laura Alfaro; Areendam Chanda; Sebnem Kalemli-Ozcan; Selin Sayek
    Abstract: The empirical literature finds mixed evidence on the existence of positive productivity externalities in the host country generated by foreign multinational companies. We propose a novel mechanism, which emphasizes the role of local financial markets in enabling foreign direct investment (FDI) to promote growth through backward linkages, shedding light on this empirical ambiguity. In a small open economy, final goods production combines the production processes of foreign and domestic firms, which compete for skilled labor, unskilled labor, and intermediate products. In order to operate a firm in the intermediate goods sector, entrepreneurs must first develop a new variety of intermediate good. Innovation and imitation both require capital costs, which must be financed through the domestic financial institutions. The more developed the local financial markets are, the easier it is for credit constrained entrepreneurs to start their own firms. Thus the number of varieties of intermediate goods increases, causing positive spillovers to the final goods sector. As a result the host country benefits from the backward linkages between foreign and domestic firms since the local financial markets allow these linkages to turn into FDI spillovers. Our calibration exercise confirms our analytical results. In particular, the results show that the same amount of increase in FDI, regardless of the reason of the increase, generates three times more additional growth in financially well-developed countries than in financially poorly-developed countries. The calibration exercise also shows the importance of the other local conditions such as market structure and human capital–the absorptive capacities–for the effect of FDI on economic growth.
    Keywords: FDI spillovers, backward linkages, financial development, economic growth
    Date: 2006–06
  2. By: Alejandro Gaytan; Romain Ranciere
    Abstract: How do the liquidity functions of banks affect investment and growth at different stages of economic development? How do financial fragility and the costs of banking crises evolve with the level of wealth of countries? We analyze these issues using an overlapping generations growth model where agents can invest in a liquid storage technology or in a partially illiquid Cobb Douglas technology. By pooling liquidity risk, banks play a growth enhancing role in reducing inefficient liquidation of long term projects, but they may face liquidity crises associated with severe output losses. Middle income economies may find optimal to be exposed to liquidity crises, while poor and rich economies have more incentives to develop a fully covered banking system. Therefore, middle income economies could experience banking crises in the process of their development and, as they get richer, eventually converge to a financially safe long run steady state. The model also replicates the empirical fact of higher costs of banking crises for middle income economies. Finally, using GMM dynamic panel data techniques for a sample of 83 countries we show that growth implications of the model are consistent with the empirical facts.
    Keywords: OLG growth models, liquidity, financial intermediation, financial fragility, banking crises
    JEL: E44 G21 O11
    Date: 2005–06
  3. By: Govori, Fadil
    Abstract: Economic system relies heavily on financial resources and transactions, and economic efficiency rests in part on efficient financial markets. Financial markets consist of agents, brokers, institutions, and intermediaries transacting purchases and sales of securities. The many persons and institutions operating in the financial markets are linked by contracts, communications networks which form an externally visible financial structure, laws, and friendships. The financial market is divided between investors and financial institutions.
    Keywords: Markets and Institutions
    JEL: G23 G21 G20 G22
    Date: 2006–11–26
  4. By: Thomas Lagoarde-Segot; Brian M. Lucey
    Abstract: The objective of this paper is to review the transmission mechanisms uniting equity market development and economic growth in developing countries. We find that the theoretical impact of equity markets is ambiguous. At the domestic level, the allocation function of equity markets appears conditioned by the extent of informational efficiency. Turning to international linkages, theoretical models suggest that equity market integration lowers the cost of capital, increases financial vulnerability and has a mixed impact on capital flows. Taking this into account, two conclusions arise. First, equity market development policies should focus on reaching and maintaining adequate levels of institutional transparency. Second, the optimal degree of international integration depends on the society’s preference between international accessibility and domestic stability.
    Keywords: Equity Markets, Economic Development.
    Date: 2006–11–16

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