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The role of debt and equity changes over time and with the level of development. What are these changes, and why should they systematically occur across different countries and time periods? This article characterizes financial innovation as a dynamic process that both influences and is influenced by the development of the real sector. It focuses on the emergence and development of equity markets, using a model that allows for growth and for capital accumulation that is financed externally through a combination of debt and equity. As an economy develops, the aggregate ratio of debt to equity will generally fall; yet, debt and equity remain complementary sources for the financing of capital investments. The results suggest how various government policy actions might affect capital accumulation and equity market activity. Economists have long believed that financial markets and institutions are impor-tant factors in determining the wealth of nations. In the last five years or so, there has been a veritable renaissance of interest in this topic. This growing, recent literature has produced several important new reasons to think that finan-cial institutions matter very much in the development process. Most of this re-
Boyd et al. (Wed,) studied this question.