Financial constraints and economic development: the role of innovative investment

This paper argues that accounting for firms' endogenous productivity growth plays an important role in understanding the link between financial and economic development. First, using a simple analytically tractable model, it shows that incorporating endogenous investment in firm productivity into the model amplifies the negative impact of firm financing constraints on economic development, as long as the models with endogenous and exogenous productivity growth are calibrated to match the same data on firm size dynamics and firm owners' income. Second, the paper embeds productivity investment into an otherwise standard variation of the Bewley-Aiyagary-Hugget model used in the existing literature to evaluate the impact of borrowing constraints on economic development. It compares the effects of firm financing constraints in the two models, with endogenous and exogenous firm productivity growth, calibrated in such a way that they are observationally equivalent in the benchmark unconstrained environment. The main result is that the impact on financing constraints on measured TFP and GDP is significantly bigger in the model in which the evolution of firm productivity is endogenous. While measured TFP and GDP fall by 5% and 28% in the model with exogenous productivity growth, they fall by 13% and 37%, respectively, in the model in which firm productivity grows endogenously.