Financial Frictions and the Persistence of History: A Quantitative Exploration

This paper presents a quantitative model of economic transitions. We explicitly model resource misallocation and financial frictions to explain observed transitional dynamics that are not consistent with the standard neoclassical growth theory. When calibrated to empirical evidence on resource misallocation and financial frictions in less developed countries, our model economy converges slowly to the steady state—it typically takes four times as long to cover half the distance to the steady state as the neoclassical benchmark. The interest rate and investmentto-output ratio start low and rise over time in the early phases of economic development. In addition, the model generates an endogenous TFP dynamics, reflecting the gradual unwinding of misallocation along transitions.