Financial System And Endogenous Economic Growth

With respect to the relationship between finance and growth, there are two popular study approaches. Firstly, many scholars study different types of financial structure and their performance in promoting economic growth from the perspective of financial function in order to find an ideal financial structure. This approach fails to identify the role of financial system in capital accumulation and innovation which are major driving forces of economic growth. Secondly, an extensive literature studies the empirical evidence linking the development of finance sector to economic growth. It doesn't construct a theoretical model to illustrate the relationship between finance and growth. Due to these problems, there exist a lot of debates on this topic among economists. One reason for this problem is that no major breakthrough occurred in economic growth theory before the 1980s and no powerful theoretic frameworks are available to study this issue.Fortunately, the rise of endogenous growth theory brings about the rapid progress of growth theory. The creative destruction model developed by Aghion and Howitt is an active branch in this field. This line of model elaborates Shumpeter's idea about"creative destruction"and incorporates innovation and capital accumulation into a single growth model. It argues that capital accumulation and innovation are complementary factors in long-run growth. My paper tries to integrate financial sector into this framework to analyze the channels through which financial system affects growth.Holmstrom and Tirole (1997) constructed a model describing the finance decision of firms. They argued that firms with lower marketable collateral and higher incentive problems borrow from banks, while wealthier firms rely on unintermediated market-finance. This paper extends H-M's idea to startups'finance decision process. This paper assumes that the major role of bank credit and capital market is to promote capital accumulation, while that of venture capital is to promote innovation. Based on this assumption, this paper solves the conditions under which traditional firms and startups are financed respectively. According to these two conditions, we establish the mechanisms through which financial sector promotes capital accumulation and innovation. After that, this paper introduces the identified mechanisms into A-H model and the model construction is completed. The paper is divided into three parts, ten chapters. The first part consists of chapter one and chapter two, introduction and literature review. The next four chapters from chapter three to chapter six constitute part two constructing a theory model on the relationship between financial system and economic growth. The last four chapters are the final part of this paper. It examines the case of U.S. economy making use of the framework developed previously. The paper concludes by reviewing the implications of the model for Chinese economy.The main study approach and findings of this study are as follows:1. The relationship between financial system and economic growth are studied under A-H model, and a consistent model is developed.2. The approach and perspective on finance and growth study are innovated. This study begins by examining the driving forces of economic growth, modeling the mechanism through which financial sector promotes capital accumulation and innovation, and then constructs a framework explaining how financial sector promotes economic growth.3. According to Holmstrom and Tirole (1997), this paper explores the basis for capital accumulation from microeconomic perspective and concludes that the investment of an economy is determined by enterprises'initial wealth and the efficiency of financial sector. The more efficient is the financial system, the more rapid is the capital accumulation.4. Extending the idea of H-T model to VC and startup relationship, the condition under which the startups can be financed by VCs is determined, which is a function of startups'potential revenue. This condition is an alternative expression of innovation-promoting mechanism by VC.5. Well-functioned financial sector can promote innovation and capital accumulation effectively and keep the economy growing on a balanced path.6. Not only can the model of this paper explain U.S. rapid growth, but also provide a reasonable explanation about internet bubble and sub-prime mortgage crisis and their effects on U.S. economic growth.