This project aims to develop a quantitative macroeconomic model to study the effects of financial development on factor allocation and macroeconomic performance. We pursue to answer how financial development influences the joint determination of investment finance and capital-labour ratio choice for European based companies. The findings in this project will shed light on the importance of financial constraints for the allocational efficiency of factor inputs across production firms and in turn the role of financial development policies in explaining the total factor productivity (TFP) differences across European economies. The proposed project has four main objectives. Our first objective is to construct a general equilibrium macro model and derive theoretical implications to answer the question whether financial development improves the allocational efficiency of capital-labour ratio across different production units and affect industry total factor productivity. By applying dynamic panel data estimation techniques for a large sample of European firms from various countries we will also empirically test whether the variations in the level of financial development affects the sensitivity of firm level capital labour ratio with respect to balance sheet conditions. Our final objective in the project is to conduct a quantitative macro analysis and explore whether the distortions in firm level capital-labour choice have quantitatively significant implications for the industry wide misallocation of factors of production and industry total factor productivity. For this purpose, we will run counterfactual policy experiments to measure the variations in the sensitivity of capital labour choice with respect to balance sheet conditions at the firm level and the TFP gains at the industry level in response to the variations in financial development policies conducted in different European countries.
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