Essays on Macroeconomics, Development and Financial Markets

Abstract

In this dissertation, I study macroeconomic issues in cross-country development. The chapters within provide theory and evidence for the dependence of economic development across countries on financial markets and financial contracting. In the first chapter, I ask: Why is macroeconomic volatility in poor countries so much higher than in rich countries? And to what extent can policy improve welfare by mitigating this volatility? I evaluate the extent to which frictions in financial markets generate more volatile macroeconomic outcomes in poor countries. I motivate my focus on financial frictions with a business cycle accounting exercise using a diverse sample of 89 countries. I identify sources of the empirical relationship between output levels and the volatility of output, consumption and investment. I find that a relevant model of cross country volatility should give a central role to distortions affecting capital accumulation. Accordingly, this paper presents a two-sector stochastic growth model in which firms face constraints to accessing external funds. Firms must collateralize the value of their capital stock against debt issuances. Because contract enforcement is more costly in poor countries, lenders extend less credit and firms are more debt constrained. When firms are debt constrained, the price of capital amplifies the effect of productivity shocks and generates an inefficiently large reallocation of capital across sectors. Consequently, poor countries exhibit higher volatility of investment, output and consumption. I then compute constrained efficient allocations in which a social planner understands the effects of investment decisions on the price. Constrained efficient allocations generate a smaller correlation between income levels and volatility, reflecting a disproportionately large reduction in volatility for poor countries. In the second chapter, I comment on a recent literature that has proposed that cross country differences in the allocation of resources across productive and unproductive firms can generate large differences in aggregate productivity. Subsequent research has demonstrated that the cross country differences in the effectiveness of financial markets in allocating capital to its most productive uses can generate empirically plausible productivity differences. However, these studies focus on relatively high income economies. This paper argues that poor countries with substantial financial market imperfections actually exhibit little misallocation across firms. I demonstrate this point using an endogenous growth model in which firms externally finance capital investment and may default on repayment. For middle to high income countries, the model generates larger cross-firm misallocation when there are worse financial conditions, but in poor countries the model generates less misallocation when financial conditions are worse. The key mechanism is that when financial contracts are more costly to enforce, creditors lend less and firms accumulate capital more slowly. When contracts are too costly to enforce, the benefits of entry are low and there exist few incumbent firms to demand credit. As a result, the allocation of resources across firms is less distorted. However, the entry of firms is highly distorted and accounts for a majority of productivity growth. Therefore, firm entry is particularly important when accounting for productivity differences in poor countries.