Working Papers,
Lund University, Department of Economics

Abstract: This paper theoretically studies the role of the financial system in promoting macroeconomic stability and growth. It also explains endogenously the development of the financial system as part of the growth process. The productive sector engages in R\&D activities, and finances its activities through access to the financial system. While vertical innovation spurs economic growth, horizontal innovation creates new industry sectors, and thus enhances industry diversification. Higher industry diversification deepens the financial system by improving its ability to finance the productive sector. Economies that are more diversified, and thus more financially developed, have higher growth rates and are less volatile. There is a role for the government to subsidize innovation, especially horizontal innovation.

Keywords: vertical innovation; horizontal innovation; industry diversification; financial development; economic growth; imperfect information

JEL-codes: E22; E32; E44; O16; O30; O41

24 pages, September 20, 2006

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