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Investor Protection, Optimal Incentives, and Economic Growth

by Rui Castro, Gian Luca Clementi, and Glenn MacDonald

Notice: a previous version of this paper circulated under the title "Optimal Financing Contracts, Investor Protection, and Growth".

Paper (PDF Format)

 

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 protection 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 form 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.