A large body of evidence suggests that poor countries tend to invest less (have lower PPP-adjusted investment rates) and to face higher relative prices of investment goods. It has been suggested that this happens either because these countries have lower TFP in the investment-good producing sectors, or because they are subject to greater investment distortions. What is still to be understood, however, is what are the causes of these shortcomings. In this paper we address this question by providing a micro-foundation for the cross-country dispersion in investment distortions. Our analysis rests on two premises: 1) countries differ with respect to the rights enjoyed by outside investors (such as bondholders and minority shareholders) and 2) firms producing capital goods face a higher level of idiosyncratic risk than their counterparts producing consumption goods. In a model of capital accumulation where the protection of investors' rights is incomplete, this difference in risk induces a wedge between the returns on investment in the two sectors. The wedge is bigger, the lower the investor protection. In turn, this implies that countries endowed with weaker institutions are poorer, face higher relative prices of investment goods, and invest a lower fraction of their income. Our analysis also suggests that the mechanism we study may be quantitatively important.

Recent empirical evidence has suggested a positive association between various measures of investor protection and financial markets' development, and between financial markets' development and economic growth. We introduce investor protection in a simple extension of the two-period overlapping generations model of capital accumulation and study how it affects economic growth. Investor protection is positively related to risk-sharing. As is standard in models of investment with risk-averse agents, better protection (better risk sharing) results in a larger demand for capital. This is the demand effect. A second effect, which we call the supply effect, follows from general equilibrium restrictions. For a given aggregate capital stock, better protection (i.e. a higher demand schedule) implies a higher interest rate. The aggregate resource constraint then implies lower income for the entrepreneurs (the younger cohort). As a result, current savings and the supply of capital in the following period decrease. It turns out that the strength of the supply effect is greater, the tighter the restrictions on capital flows. Therefore our model predicts that the positive effect of investor protection on growth is stronger for countries with lower restrictions. We find that the data provides some support for this prediction.

Recent empirical evidence has suggested a positive association between various measures of investor protection and financial markets' development, and between financial markets' development and economic growth. We introduce investor protection in a simple extension of the two-period overlapping generations model of capital accumulation and study how it affects economic growth. Investor protection is positively related to risk-sharing. As is standard in models of investment with risk-averse agents, better protection (better risk sharing) results in a larger demand for capital. This is the demand effect. A second effect, which we call the supply effect, follows from general equilibrium restrictions. For a given aggregate capital stock, better protection (i.e. a higher demand schedule) implies a higher interest rate. The aggregate resource constraint then implies lower income for the entrepreneurs (the younger cohort). As a result, current savings and the supply of capital in the following period decrease. It turns out that the strength of the supply effect is greater, the tighter the restrictions on capital flows. Therefore our model predicts that the positive effect of investor protection on growth is stronger for countries with lower restrictions. We find that the data provides some support for this prediction.

In this paper we provide a thorough characterization of the asset returns implied by a simple general equilibrium production economy with convex investment adjustment costs. When households have Epstein-Zin preferences, there exist plausible parameter values such that the model generates unconditional mean risk-free rate and equity return, and volatility of consumption growth, which are in line with historical averages for the US economy. Consistently with the data, the price-dividend ratio is pro-cyclical and stock returns are predictable (and increasingly so as the time horizon increases), while dividend growth is not. The model also implies realistic values for (i) the correlation of the risk-free rate with output growth and consumption growth and (ii) the correlation pattern between risk-free rate, equity return, and equity premium. The risk implied by the model is rather low. Given the work of Rabin (2000) among others, it is not surprising that our Epstein-Zin agent exhibits a much higher risk aversion when faced with substantially larger risks. This shortcoming, however, does not extend to the case in which agents are disappointment averse in the sense of Gul (1991). When faced with a lottery that has a coefficient of variation 100 times as large as that implied by our model, a disappointment averse agent displays the same relative risk aversion as an expected utility agent with logarithmic utility!

We document and discuss a dramatic change in the cyclical behavior of aggregate skilled hours since the mid‐1980s. Using CPS data for 1979:1–2003:4, we find that the volatility of skilled hours relative to the volatility of GDP has nearly tripled since 1984. In contrast, the cyclical properties of unskilled hours have remained essentially unchanged. We evaluate whether a simple supply/demand model for skilled and unskilled labor with capital‐skill complementarity in production can help explain this stylized fact. Our model accounts for about 60% of the observed increase in the relative volatility of skilled labor.