Institutions, Trade and the Political Economy of Financial Development

Abstract

To study how financial development depends on trade openness and different types of institutions, we present a political economy model in which the elite can repress the financial market at some cost. The elite can persuade the government to set an interest rate ceiling, and it can then channel all capital supplied toward itself. It can thereby keep its capital costs low and limit the domestic production of modern goods by ensuring that ordinary citizens cannot get sufficient capital to produce these goods. The latter raises the prices of modern goods under autarky, but not under free trade. For most world market prices, greater trade openness therefore reduces the elite's incentive to repress the financial market and increases financial development. Better property rights institutions make financial repression more costly for the elite and tend therefore to increase financial development. Better contracting institutions lower the costs of financial transactions, which has countervailing effects on equilibrium financial development. These predictions are consistent with the empirical evidence.