Why do living standards differ so much across countries? Across time and space, we observe large differences in income per capita across countries. Factor difference between richest and poorest deciles of the income distribution are of 20 folds in 1960 to more than 50 fold in 2014. A natural question arises, what accounts for the large differences in income per capita across countries? The literature subscribes to productivity (TFP) in accounting for bulk of the differences in income per capita across countries. Then the natural question is, what accounts for the large productivity differences across countries? In this paper, I exploit the strong link between financial and economic development to explain the large differences in living standards across countries. It is well documented that poor countries with low levels of financial development (prominent financial Frictions) are characterized with lower aggregate productivity, lower investment in productivity, less employment at large firms and smaller average firm size (Bento, 2021). I employee equity constraints as a proxy for financial frictions and build a novel model of (mis)allocation with the presence of correlated and size-dependent distortions.

In this paper, we study the impact of financial frictions on average firm size and aggregate productivity in a model where constrained firms invest in their productivity at the start of their life-cycle. The contribution of our paper is two-fold. Firstly, we document that in addition to the strong relationship between financial frictions and i) lower aggregate productivity, ii) lower investment in productivity, iii) smaller average firm size (Bento, 2021), we find that financial frictions disproportionally impact the more productive agents in the economy, proxied by elasticity of distortions with respect to productivity (Restuccia et al). Secondly, we develop a highly tractable quantitative model that generates outcomes consistent with the empirical facts. The model is novel in that we consider jointly a framework with equity constraints as a proxy for financial frictions introduce mis(allocation) in the presence of correlated and size-dependent distortions.

• Financial Frictions
• Misallocation
• Firm Size