The University of Manchester Discussion Paper Series Stock Market Development and Economic Growth: A matter of informational problems

This paper aims to provide further insights into the linkages between stock market development and economic growth within the context of a dynamic general equilibrium framework of informational asymmetries, endogenous contract choice and capital accumulation. When firms have access to different projects with different unobservable rate of returns, the market valuation of those projects is an “average” value reflecting the expected return across all projects. Consequently, as in a typical lemon’s market, higher return projects are penalised since they attract lower than fair prices. This informational cost, or dilution cost, depends on the degree of informational asymmetry in the market, as well as on the type of financial contract issued by the firm to finance those projects. Typically, an equity contract involves higher dilution costs than a debt contract, which, in turn, might involve other forms of costs, such as bankruptcy costs. The combinations of these costs determines the prevailing financial contract in the market. On this grounds, we develop a model in which, as capital accumulates, the level of information asymmetry decreases, and, consequently, the development of stock market is the result of a change in the optimal financial choice of firms which switch from debt financing to a less costly – lower dilution costs – equity financing.