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Endogenous Financial Friction and Growth

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Published/Copyright: May 17, 2024

Abstract

Financial frictions have been considered a crucial factor in explaining growth disparities across countries. These frictions are typically viewed as an exogenous constraint on borrowing capacity that is assumed to be invariant to economic conditions, such as the level of GDP and business cycle fluctuations. However, assuming the exogenous constraint on borrowing often leads to unrealistic dynamics in macroeconomic variables, such as constant investment-to-GDP and loan-to-value ratios. Motivated by these limitations, we develop a growth model in which the severity of the borrowing constraint is endogenously determined. The borrowing constraint adversely affects growth and amplifies the negative effect of volatility on growth. However, these growth effects gradually disappear as the economy continues to grow, because debtors become more willing to honor their debts along with economic growth, resulting in an endogenous relaxation of the borrowing constraint.

JEL Classification: E22; O16

Corresponding author: Minhyeon Jeong, Korea Institute for International Economic Policy, Sejong, South Korea, E-mail:

The author benefited from valuable comments by Costas Azariadis, Rodolfo Manuelli, Yongseok Shin, Ping Wang, Raul Santaeulalia-Llopis, Steve Williamson, Kyoung Hyun Koo and audiences in various seminars.


Acknowledgements

The author is grateful to the editor and anonymous referees for their insightful feedback, which greatly enhanced the paper. The author also benefited from valuable feedback provided by Costas Azariadis, Rodolfo Manuelli, Yongseok Shin, Ping Wang, Raul Santaeulalia-Llopis, Steve Williamson, Chul-In Lee, Kyoung Hyun Koo, and audiences at various seminars.

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Supplementary Material

This article contains supplementary material (https://doi.org/10.1515/bejm-2024-0028).


Received: 2022-11-09
Accepted: 2024-04-21
Published Online: 2024-05-17

© 2024 Walter de Gruyter GmbH, Berlin/Boston

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