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A paradigm is presented in which both the extent of financial intermediation and the rate of economic growth are endogenously determined. Financial intermediation promotes growth because it allows a higher rate of return to be earned on capital, and growth in turn provides the means to implement costly financial structures. Thus financial intermediation and economic growth are inextricably linked in accord with the Goldsmith-McKinnon-Shaw view on economic development. The model also generates a development cycle reminiscent of the Kuznets hypothesis. In particular, in the transition from a primitive slow-growing economy to a developed fastgrowing one, a nation passes through a stage in which the distribution of wealth across the rich and poor widens. JOURNAL OF POLITICAL ECONOMY io8o JOURNAL OF POLITICAL ECONOMY stochastic structure of the economic environment will be delimited in the following way. ASSUMPTION A. The aggregate shock Ot is governed by the timeinvariant distribution function F(O,). Let 0 = [0, 0] C R + ? and F: 0 -e [0, 1]. Furthermore, suppose that E[ln[+O + (1 -+8]] = f {ln[(lO + (1 -4) 8]}dF(O) > In 8 > -In f for all + E [0, 1]; by Jensen's inequality, this implies E[O] > 8 > 1/13. ASSUMPTION B. For each individual j E [0, 1], the idiosyncratic shocks Et(J) are drawn from the distribution function G(Et(j)

A paradigm is presented where both the extent of financial intermediation and the rate of economic growth are endogenously determined.Financial intermediation promotes growth because it allows a higher rate of return to be earned on capital, and growth in turn provides the means to implement costly financial structures.Thus, financial intermediation and economic growth are inextricably linked in accord with the Goldsmith-McKinnon-Shaw view on economic development. The model also generates a development cycle reminiscent of the Kuznets hypothesis. In particular, in the transition from a primitive slow-growing economy to a developed fast-growing one, a nation passes through a stage where the distribution of wealth across the rich and poor widens. *Greenwood, Federal Reserve Bank of Minneapolis and University of Western Ontario; Jovanovic, New York University.The views expressed herein are those of the authors and not necessarily those of the Federal Reserve Bank of Minneapolis or the Federal Reserve System. This paper is preliminary and is circulated to stimulate discussion. It is not to be quoted without authors' permission. J J J J J walk with positive drift, since E[&i(0.(0.+ e.) + (1-0:)*)] + 61 P > 0 for a11 \ e l 0 . 1 ] b y J J J J J assumptions (A) and (B). Thus, k t must become absorbed into the set [k~,co) with probability one. For more detail see Feller (1971).