SBE-SES 0820318: PI Shin (U of Wisconsin); Co-PI Buera (NBER, subaward)
Understanding the sources of cross-country differences in economic development is a central question in the social sciences. Recent empirical research has provided some answers: Cross-country income differences are mainly explained by the low total factor productivity in developing countries, particularly in producing investment/tradable goods. Misallocation of resources across production units is an important source of their low productivity. Well-functioning financial markets are an important institution missing in these countries. This project constructs a unified framework where financial frictions and resource misallocation are explicitly modeled and their impact on economic development is quantitatively evaluated.
This project first analyzes how financial frictions lead to resource misallocation, and how some industrial sectors are more vulnerable to financial frictions than others. It is shown that a model incorporating sectoral differences in the scale of establishments explains why developing countries are particularly unproductive in producing investment/tradable goods. This model has implications on the patterns of establishment size distribution across countries and across sectors. Such model predictions are tested against establishment-level data. As part of this project, a comprehensive data set on the size distribution of establishments in developing (e.g. Mexico and India) and developed countries (e.g. the US) is put together, to be shared with other researchers.
The project also studies dynamic effects of an economic reform that partially eliminates distortions in the economy. It is shown that the interaction between financial frictions and resource misallocation is crucial in understanding growth experiences of developing countries that are incompatible with standard theories. Consistent with the data, the model generates a slow transition to a higher state of economic development, low interest and investment rates in the early stages of development, and endogenous productivity dynamics.
Finally, this project studies how the interaction between international and domestic financial markets determines economic development. The model is used for studying the transition dynamics following liberalizations of cross-border production factor flows, which are an important part of growth-enhancing reform packages in many developing countries. In particular, it addresses the puzzling observation that countries going through a period of output and productivity growth tend to export capital, contradicting the standard theory. In addition, other dimensions of factor flows are explained, such as foreign direct investment flowing from developed to developing countries while entrepreneurial talent moves in the opposite direction (brain drain) at the same time.
More broadly, this project is related to the literature that places institutions at the center of economic development: Financial frictions in this project are modeled as arising from imperfect enforcement of contracts, an important topic in the broader institutions literature. In this context, this project sets an example of how to quantitatively analyze the mechanisms through which institutions determine economic development. This project is also useful for the design and execution of public policies. By applying its quantitative framework, one can answer important questions on economic reforms: How soon will reforms start to pay off? How fast will economic growth trickle down to the poor? What are the optimal policies on international factor mobility?
