Firm Dynamics During an Improvement in Financial Development

Abstract

A better set of financial institutions enables firm access to external finance with less consequent distortion of firm policies, such as investment, entry and exit policies. At the limit, there is no distortion. In contrast, there are many different ways that a poor set of financial institutions may distort firm policies. I consider how the transition towards better financial development depends on the type of poor financial development initially present. I develop a model in which firm dynamics, including entry, investment and exit, are affected by financial development. I contrast the transition to a financial system with no distortions from two initial states, one with restricted use of external finance by firms (e.g., credit constraints) and the other with lax use of external finance by firms (e.g., during a bubble). I highlight substantial differences in firm dynamics, including patterns of entry and price levels, across these two transitions towards better financial development.