Abstract
This paper studies a novel type of misallocation of credit between investments of varying liquidity. One type of investment is more liquid, i.e., its return is more pledgeable, and the other is more productive. Low liquidities of both types imply that the allocation of credit is constrained inefficient and that there is overinvestment in the liquid type. Constrained inefficient equilibria feature too high interest rate, too much investment and too little consumption. Financial development reduces long-term welfare and output in a constrained inefficient equilibrium if it raises the liquidity of the liquid type. A debt tax can achieve constrained efficiency.
Highlights
Financial frictions can distort the allocation of credit in the economy, resulting in low output and welfare
This paper studies a novel type of constrained ine ciency in credit allocation in an economy consisting of high-return/low-liquidity and low-return/high-liquidity projects, which involves overinvestment in the latter
In contrast to other models which feature the crowding out e ect, government bonds crowd out private investment while having no e ects on the interest rate
Summary
Financial frictions can distort the allocation of credit in the economy, resulting in low output and welfare. I show that nancial development that is conventionally thought to bring economies with nancial frictions closer to the rst best may reduce output and welfare because it can increase the extent of misallocation Such adverse e ects are present when the allocation of credit is constrained ine cient, and nancial development raises the liquidity of the low-return/high-liquidity projects. Given that the second best allocation may be achieved using simple regulations such as a debt tax, this implies a stronger case for public support of young rms and SME nancing than what was previously understood These results suggest that policies such as developing private bond markets, loan guarantees, and development of primary and secondary markets for asset securitization should be pursued with more caution in low-income and emerging market economies. An interest rate below the growth rate of the output must be raised to make a Pareto improvement
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