Al Development and Economic Growth

We develop a theory of financial development based on the costs associated with the provision of external finance. These costs are assumed to arise within an environment where informational asymmetries between borrowers and lenders are costly to resolve. When borrowing is limited, producers with access to financial intermediary loans obtain higher returns to investment than other producers. This creates incentives for others to undertake the technology adoption necessary to access investment loans. Over time, as increasing numbers of producers gain access to external finance, borrowers’ net worth rises relative to debt. This reduces the costs of financial intermediation and raises the overall return on investment. The theory is consistent with recent evidence that financial development reduces the costs associated with the provision of external finance and increases the rate of economic growth. Furthermore, the theory predicts that financial development raises the return on loans and reduces the spread between borrowing and lending rates.