Furthering the role of corporate finance in economic growth

Abstract

My research question is: Why do countries with similar rates of saving differ in economic growth? My thesis addresses this question by formulating an endogenous growth model using the Cobb-Douglas production function. My model disaggregates the rate of saving into the retention ratio and the household saving ratio and connects these ratios with three new parameters representing respectively the efficiency of financial institutions, the decision-making of managers, and barriers to technology diffusion. These three financial parameters make it possible to distinguish between quantitative and qualitative investments and to measure the growth rates of output, capital, and technological progress. Endogenous growth in technology neutralizes diminishing returns to capital. The Cobb-Douglas production function assumes diminishing marginal productivity under constant returns to scale. My model, however, measures the growth rate of per capita output under the balanced growth state/constant returns to capital situation. This situation is guaranteed when the relative share of profit is within the critical relative share of profit. A set of combination of the three financial parameters holds under diminishing returns to capital, yet the diminishing returns to capital situation turns to the balanced growth state situation by using delta defined as the elasticity of quality improvement with respect to effective labour units attached to a machine. An extreme case corresponds with the Solow and O'Connell (including Harrod-Domar) models, where the three financial parameters are all 1.0, with no technological progress. Simulation results demonstrate several new fact-findings. These fact-findings come from the characteristics of my model or the relationships between the growth rate of “per capita” output in the long-run (hereunder the growth rate) and the three financial parameters and delta, where the growth rate converges by setting delta = the relative share of profit. First, if the rate of saving increases, the growth rate also increases linearly. This is more definitely evident than the result of Mankiw, Romer, and Weil [1992]. Second, under a fixed rate of saving, the growth rate changes significantly differently if each of three parameters changes: the relative share of profit, the growth rate of population, and the retention ratio. In particular, the change in the retention ratio influences the growth rate positively or negatively depending on the relationship between the three financial parameters that reflect corporate behaviour and the nature of financial institutions. In this respect, I cannot find literature that relates the retention ratio or dividend policy to the growth rate in the Cobb-Douglas production function. Also the change in the growth rate of population does not influence per capita growth at all. This finding is also more definite than that found in the literature. In short, the three financial parameters play an important role in economic growth. When we divide saving into corporate saving and household saving, the rate of saving as a whole is not independent of the growth rate. A proportion of corporate saving and a proportion of household saving are used for investment in quality, which accelerates productivity enhancement. Consequently, the characteristics of the corporate sectors and financial institutions of a country play a significant role in determining its long run growth rate of per capita income (even under a fixed rate of saving).