Financial Development and Financing Constraints: International Evidence from the Structural Investment Model

Abstract

This article provides evidence that financial development impacts growth by reducing financing constraints that would otherwise distort efficient allocation of investment. The financing constraints are inferred from the investment Euler equation by assuming that the firm's stochastic discount factor is a function of the firm's financial position (specifically, the stock of liquid assets). The magnitude of the changes in the cost of capital is twice as large in a country with a low level of financial development as in a country with an average level of financial development. The size effect, business cycles, and legal environment effects are also considered.