Financial Intermediation and Economic Development: A Quantitative Assessment∗

We present a model in which the importance of financial intermediation for economic development can be measured. We generate financial differences by varying the degree to which contracts can be enforced. Economies where enforcement is poor direct less capital to the production sector, and employ less efficient technologies. Calibrated simulations reveal that the resulting effect on output is important. Furthermore, the model correctly predicts that the average scale of production should rise with the quality of enforcement. Finally, we find that the importance of financial development rises with the importance of capital in production. ∗E-mail: [email protected] and [email protected]. We thank Berthold Herrendorf, Ed Prescott and Richard Rogerson for their comments, as well as seminar participants at the 2004 Annual Meeting of the Society for Economic Dynamics, Arizona State University, Texas A&M, the University of Pittsburgh, the Universidad Católica Argentina, the University of Western Ontario, Queen’s University and the Universidad de Guanajuato. The views expressed herein are those of the authors and may not reflect the views of the Federal Reserve Bank of Dallas or the Federal Reserve System.