Industrial Diversification, Financial Development and Productive Investments

This paper analyzes, from a theoretical perspective, the role of the financial system to promote growth and macroeconomic stability. It also endogenously explains the performance of the financial systems as a consequence of industrial (or sectoral) diversification. In the model, the productive sector carries out R&D activities and finances its activities through the financial system. While vertical innovation fosters economic growth, horizontal innovation creates new industrial sectors and therefore generates an increase of industrial diversification. A larger industrial diversification deepens the financial system because it improves its possibilities of financing the productive sector. A more diversified economy (better financially developed as a result) will have higher growth rates and will be less volatile. There is a role for the government to subsidize innovation, especially horizontal innovation.