Real and Financial Development Traps

The direction of causality between financial intermediation and real economic progress has been a source of discussion over long periods of time. Instead of exogenously siding with one particular direction a priori, this paper provides a different treatment on this debate by considering the interaction between financial and real sectors to be not just a question of causality, but an issue of co-evolution. In order to pursue this, I integrate features of the intermediary sector, namely financial frictions among its participants, with the standard overlapping generations model of growth. I find that depending on technical conditions, the introduction of financial frictions can cause a delay in the actual formation of the financial sector, which in turn delays the development of the real sector. Moreover, it is also possible that under certain parametric configurations, the economy’s growth trajectory will never be able to support the endogenous emergence of the financial sector, and consequently, real economic activities are forever retarded. I am greatly indebted to my late dissertation supervisor, Bruce Smith, for inspiring me to study macroeconomics in general and encouraging me to pursue the study of financial intermediation. I started working on this project under his supervision, but I was deprived of the privilege of completing it with him. I will forever miss him, as a caring mentor and a loving friend. I am also very grateful for the gracious support from Scott Freeman, Joydeep Bhattacharya, and Peter Wilcoxen. I thank them deeply for helping me cope with my advisor’s passing. Finally, I need to thank Mike Sadler, Malathi Velamuri and Macroeconomics Seminar participants at the University of Texas at Austin for their comments. Any remaining errors are mine.