The financial sector plays a critical role in affecting the aggregate economy. In the medium and long run, underdevelopment of financial markets can be an important reason for poor performance in economic growth. What is less well understood are the channels through which the financial sector impacts the aggregate economy. Substantial progress in our understanding has been made by studying the financing channel (see, e.g., Holmstrom and Tirole (1997)). However, there are puzzles that cannot be explained by this channel. Our proposed project attempts to explain the effect of financial underdevelopment on economic growth by studying a different channel — the information channel. We propose a theory of information amplification and spillover that explains the propagation effect of the financial sector. Our theory shows that financial underdevelopment results in high information frictions, which cause resource misallocation.
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