Innovation, Trade and Finance * P E

The paper proposes a model where heterogeneous firms choose whether to undertake R&D or not. Depending on R&D choice, innovative firms are more productive, have larger investment opportunities and lower own funds than non-innovating firms. As a result, innovative firms are financially constrained while standard firms are not. The efficiency of the financial sector and a coun-try's institutional quality relating to corporate governance determine the share of R&D intensive firms and the comparative advantage in innovative goods. We show how protection, R&D subsidies and financial development improve access to external finance in distinct ways, support the expansion of innovative industries and boost national welfare. International welfare spillovers depend on the interaction between terms of trade effects and financial frictions and may be positive or negative, depending on foreign countries' trade position. Tulane University. We are grateful to Evelyn Ribi for very helpful comments.