Credit constraints, selection and productivity growth

This paper presents a tractable model of innovation and growth with firm heterogeneity and financial frictions. The model is used to uncover new mechanisms linking access to credit and productivity growth, highlighting the role of selection and firm heterogeneity emerging from recent empirical findings. Three key results emerge. First, better access to credit to finance fixed operating costs allows less productive firms to survive, thereby depressing the average level of productivity and, via its effect on innovation incentives, aggregate productivity growth. Second, cheaper access to credit decreases these costs, thereby freeing resources to increase production and firm size. Larger firm size leads to more innovation and growth. The overall impact of finance on growth hinges on the relative strength of the selection and market size effect. Third, cheaper access to credit to finance the cost of entry leads to stronger product market competition which, in turn, foster stronger selection, innovation and growth.