Financial Efficiency and the Lucas Puzzle

Abstract

I present a model that provides a theoretical solution to the Lucas Puzzle using Financial Efficiency, which is a matching probability between borrowers and lenders and that may differ between countries. Savers receive only probability-adjusted returns and producers obtain only probability-adjusted capital to produce with.

I address the contention between Rodrik and Subramanian (2009) and financial globalization advocates such as Henry (2007). My model predicts that a financially underdeveloped economy is to benefit from financial integration through FDI capital inflow only if it experiences faster technological growth, or faster Financial Development than the developed economy.

Fitting the model to the data of India, I estimate the temporal evolution of Financial Efficiency and find a sharp increase in India’s Financial Efficiency since 1990, which provides a natural experiment for the theoretical prediction above and its congruence with the empirical part of the model. Increases in India’s capital per worker and Foreign Direct Investment capital inflow during the same period serve as external validation of the model.