Financial Obstacles and Inter-Regional Flow of Funds: Limited Commitment and Moral Hazard∗

A number of recent papers argue that financial frictions arising from limited commitment problems can explain large cross-country income differences. We argue that different micro financial underpinnings have potentially very different implications at both the macro and the micro level. To this end, we develop a general equilibrium framework that encompasses different regimes of frictions, and compare the implications of two concrete frictions: limited commitment and moral hazard. Aggregate productivity is depressed in the two regimes but for completely different reasons: under limited commitment capital is misallocated across heterogeneous firms. In contrast, under moral hazard, productivity is endogenously lower at the firm level because entrepreneurs exert suboptimal effort. Occupational choice, productivity and firm size distribution, income and wealth inequality, and the speed of individual transitions also differ markedly. We also present an economy with different frictions in different regions. Such mixture regimes turn out to be different from simple convex combinations of the pure moral hazard and pure limited commitment regimes, and they produce interregional patterns of aggregate income, capital and labor flows and external finance that resemble rural-urban patterns observed in the data. ∗We thank Fernando Aragon, Paco Buera, Mike Golosov, Tommaso Porzio, Yuliy Sannikov, Yongs Shin and Ivan Werning for very useful comments. For sharing their code, we are grateful to Paco Buera and Yongs Shin. Townsend acknowledges support from the Eunice Kennedy Shriver National Institute of Child Health and Human Development (NICHD) and the Consortium on Financial Systems and Poverty at the University of Chicago through a grant from the Bill & Melinda Gates Foundation.