Finance, Technology and Inequality in Economic Development

This paper develops an overlapping generations model with technology choice and imperfect credit market, in order to investigate a possible source of underdevelopment. Consistent with empirical observations in the literature, the model shows that better financial institutions that provide stronger enforceability of contracts facilitate the development of financial markets, which in turn enables firms to switch to more capital intensive technologies, thereby promoting economic development. In the presence of credit rationing, however, this technological switch widens inequality. Therefore, risk-averse agents would not be willing to improve the financial institutions to the level at whic the technological switch occurs, resulting in a development trap. A remedy is to facilitate small firmsfadoption of existing technology, rather than the newone.