Mounting evidence suggests a non-monotonic relationship between finance and growth: increases in credit over GDP lead to increases in growth at diminishing rates, and after a point growth decreases. We propose a theory based on liquidity risks that delivers this result. Our theory features a tension between the high return to capital and its illiquid nature. This tension is alleviated by the availability of credit. Initially, further access to credit offsets the detrimental effects of illiquid capital, facilitating investment and growth. Beyond some threshold however, expanded access to credit induces private bonds to compete with capital as a means of savings, which becomes detrimental to growth.
- Endogenous growth
- Heterogeneous agents