Part 2 Growing Like China In class, we assume the capital is entirely self finan
ID: 2440988 • Letter: P
Question
Part 2 Growing Like China In class, we assume the capital is entirely self financed KESE, which means bank loans are not le for the E firm. In this part, we will relax this assumption. Suppose the E firm's capital stock comprises the savings of the young entrepreneur and the bank loan, KE SE lE, where lE is the amount of bank loan. However, the choice of le is subject to a incentive-compatibility constraint, RIE ??? (SE + IE), where R1 is the lending rate of loan, PE is the return to capital, ? is a parameter. D (a) Briefly interpret the incentive-compatibility constraint using your own words. (b) Suppose the constraint is always binding, which means RIE-??? (SE + IE). What is the share of capital financed through bank loans. (c) Express c2 as a function of PE, IE, SE and R, (d) Using the incentive-compatibility constraint, eliminate le in the expression of c2. D (e) Plug the expression of c and c2 into entrepreneur's life-time utility function, and solve the optimal saving function for the young entrepreneurExplanation / Answer
We construct a growth model consistent with China's economic transition: high output growth, sustained returns on capital, reallocation within the manufacturing sector, and a large trade surplus. Entrepreneurial firms use more productive technologies, but due to financial imperfections they must finance investments through internal savings. State-owned firms have low productivity but survive because of better access to credit markets. High-productivity firms outgrow low-productivity firms if entrepreneurs have sufficiently high savings. The downsizing of financially integrated firms forces domestic savings to be invested abroad, generating a foreign surplus. A calibrated version of the theory accounts quantitatively for China's economic transition. (JEL E21, E22, E23, F43, L60, O16, O53, P23, P24, P31)