Convergence, financial development, and policy analysis

We study the relationship among inflation, economic growth, and financial development in a Schumpeterian overlapping generations model with credit constraints. In the baseline case, money is super-neutral. When the financial development exceeds some critical level, the economy catches up and then converges to the growth rate of the world technology frontier. Otherwise, the economy converges to a poverty trap with a growth rate lower than the frontier and with inflation decreasing with the level of financial development. We then study efficient allocation and identify the sources of inefficiency in a market equilibrium. We show that a particular combination of monetary and fiscal policies can make a market equilibrium attain the efficient allocation.