Financing Development: The Role of Information Costs

How does technological progress in financial intermediation affect the economy? To address this question a costly-state verification framework is embedded into a standard growth model. In particular, financial intermediaries can invest resources to monitor the returns earned by firms. The inability to monitor perfectly leads to firms earning rents. Undeserving firms are financed, while deserving ones are under funded. A more efficient monitoring technology squeezes the rents earned by firms. With technological advance in the financial sector, the economy moves continuously from a credit-rationing equilibrium to a perfectly efficient competitive equilibrium. A numerical example suggests that finance is important for growth. Jeremy Greenwood Department of Economics University of Pennsylvania 3718 Locust Walk McNeil Building, Rm 160 Philadelphia, PA 19104-6297 and NBER [email protected] Juan M. Sanchez Department of Economics University of Rochester Rochester, NY 14627 [email protected] Cheng Wang Department of Economics Iowa State University Ames, IA 50011 [email protected]