Endogenous Financial Development, Growth and Volatility∗

The paper develops a model in which both long–run growth rates and credit market development are endogenous. Agents facing idiosyncratic productivity shocks cannot perfectly commit to repay their loans, but the threat of credit market exclusion specifies endogenous debt limits preventing default in equilibrium. A growth push makes credit market participation more valuable and relaxes debt limits, reinforcing thereby the initial growth effect. Moreover, a dynamic complementarity between debt limits gives rise to multiple balanced–growth paths. A high–growth equilibrium with developed credit markets can coexist with one or two low–growth equilibria with underdeveloped credit markets. Low–growth equilibria are more volatile as they are exposed to shocks to the wealth distribution and to sunspot shocks. JEL classification: D92, E32, O16