When is Quality of Financial System a Source of Comparative Advantage?

47 Pages Posted: 12 May 2008 Last revised: 18 Sep 2022

See all articles by Jiandong Ju

Jiandong Ju

Tsinghua University - PBC School of Finance

Shang-Jin Wei

Columbia University - Columbia Business School, Finance; National Bureau of Economic Research (NBER); Centre for Economic Policy Research (CEPR)

Date Written: May 2008

Abstract

Does finance follow the real economy, or the other way around? This paper unites the two competing schools of thought in a general equilibrium framework. Our key result is that there are threshold effects defined by a set of deep institutional parameters (cost of financial intermediation, quality of corporate governance, and level of property rights protection) which can be used to separate economies of high-quality institutions from those of low-quality institutions. On one hand, for economies with high-quality institutions, the view that finance follows the real economy is essentially correct. Equilibrium output and prices are determined by factor endowment. Further improvement in the institutions does not affect patterns of output. On the other hand, for economies with low-quality institutions, the view that finance is a key driver of the real economy is essentially correct. Not only is finance a source of comparative advantage, but an increase in capital endowment has no effect on outputs and prices. Our model extends a standard one-sector, partial equilibrium model of corporate finance to a multi-sector, general equilibrium analysis. Surprisingly, but consistent with data, we show that the size of financial markets (relative to GDP) does not change monotonically with either the quality of institutions or with the factor endowment. Free trade may reduce the aggregate income of an economy with low-quality institutions. Financial capital tends to flow from economies with low-quality institutions to those with high-quality institutions.

Suggested Citation

Ju, Jiandong and Wei, Shang-Jin, When is Quality of Financial System a Source of Comparative Advantage? (May 2008). NBER Working Paper No. w13984, Available at SSRN: https://ssrn.com/abstract=1131637

Jiandong Ju

Tsinghua University - PBC School of Finance ( email )

No. 43, Chengdu Road
Haidian District
Beijing 100083
China

Shang-Jin Wei (Contact Author)

Columbia University - Columbia Business School, Finance ( email )

3022 Broadway
New York, NY 10027
United States

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Centre for Economic Policy Research (CEPR)

London
United Kingdom

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