Investor Protection, Optimal Incentives, and Economic Growth

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 it 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 from 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