Investor Protection, Optimal Incentives, and Economic Growth

Abstract

Recent empirical evidence has suggested a positive association between various measures of investor protection and financial markets' development, and between financial markets' development and economic growth. We introduce investor protection in a simple extension of the two-period overlapping generations model of capital accumulation and study how it affects economic growth. Investor protection is positively related to risk-sharing. As is standard in models of investment with risk-averse agents, better protection (better risk sharing) results in a larger demand for capital. This is the demand effect. A second effect, which we call the supply effect, follows from general equilibrium restrictions. For a given aggregate capital stock, better protection (i.e. a higher demand schedule) implies a higher interest rate. The aggregate resource constraint then implies lower income for the entrepreneurs (the younger cohort). As a result, current savings and the supply of capital in the following period decrease. It turns out that the strength of the supply effect is greater, the tighter the restrictions on capital flows. Therefore our model predicts that the positive effect of investor protection on growth is stronger for countries with lower restrictions. We find that the data provides some support for this prediction.

The economic effects of improving investor rights in Portugal

“…This may lead to a decline in saving (and investment), as income is redistributed away from entrepreneurs-the agents responsible for all saving in the model. See Castro et al (2004Castro et al ( , 2009) for a more detailed discussion. By considering the dispersion in firm-size, Fig.…”

“…Our artificial economy is the one developed in Castro et al (2004Castro et al ( , 2009. It is an extension of the standard Overlapping Generations growth model, featuring imperfect investor protection.…”

“…Apart from Castro et al (2004Castro et al ( , 2009, other contributions to this literature are Amaral and Quintin (2007), Antunes et al (2008), Erosa and Hidalgo-Cabrillana (2008), Albuquerque and Wang (2008), Buera and Shin (2008a) and Buera et al (2009). These papers are mostly concerned with explaining the cross-country variation in economic outcomes.…”

“…It turns out that the formulation we adopt is formally equivalent to this one, but leads to a simpler characterization of the optimization problem. SeeCastro et al (2004).…”

Entrepreneurship in macroeconomics

“…The main idea is that, if the distribution is very concentrated, only a few agents are able to invest in growth-enhancing activity and this reduces growth. The role of financial frictions is also central to the analysis of Castro et al (2004).…”