Modeling Financial Innovation and Economic Growth: Why the Financial Sector Matters to the Real Economy

The author devises a simple way of incorporating the financial sector into a growth model that is pedagogically useful. Financial innovation raises the efficiency of financial intermediation by increasing the variety of financial products and services, resulting in improved matching of the needs of individual savers with those of firms raising funds for expanding future production. The resulting capital accumulation leads to economic growth. He discusses the comparative statics and simple dynamics of this model and uses the model to study the effects of financial liberalization as well as changes in patent laws and accounting standards. The model may be extended to include real research and development as a symbiotic source of endogenous growth.