Financing Development: The Role of Information Costs

How does technological progress in financial intermediation affect the economy? To address this questiona costly-state verification framework is embedded into a standard growth model. In particular, financialintermediaries can invest resources to monitor the returns earned by firms. The inability to monitorperfectly leads to firms earning rents. Undeserving firms are financed, while deserving ones are underfunded. A more efficient monitoring technology squeezes the rents earned by firms. With technologicaladvance in the financial sector, the economy moves continuously from a credit-rationing equilibriumto a perfectly efficient competitive equilibrium. A numerical example suggests that finance is importantfor growth.[...]