Development banking under weak institutions and imperfect credit markets

Abstract

Governments have created development banks in hopes of accelerating growth. Theoretical growth models that assess the pertinence of these banks are scarce and, none of them analyzes the implication of these banks under weak institutions and underdeveloped financial markets, which are two common problems in poor countries. This article studies the implications of subsidies to producers, a monopoly bank, or to a development bank, for the technology adoption and welfare in a Schumpeterian growth model in which creditors cannot completely eradicate moral hazard. I find that under these circumstances, the innovator will under-invest in research and, although subsidies contribute to a higher level of technology in the economy, they may harm the welfare of the working class. Subsidies to a development bank can be the most effective measure in terms of catching up with advanced economies, but this policy can be the most negative for the economic environment by diverting a large amount of resources from investment in research. Finally, this policy harms workers’ welfare when they finance the subsidy.