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by Borja
Larrain
No. 3, January 2005 - June 2005
Motivation for the Research
The fact that finance can affect real activity is well established
by now. In general, the evidence shows that financial arrangements
are an important driving force of many real-side phenomena
and not just a companion or by-product of the real economy.
This paper explores how stock market development affects
cross-country differences in relative prices, also known
as the real exchange rate. The real exchange rate is a key
variable for making comparisons of the cost of living in
different countries and for determining the current account
balance.
Research Approach
The author develops a small-open-economy model, estimated
by cross-section regression analysis on data from 82 countries,
and analyzes its implications to explain the connection between
stock market development and relative prices. The model examines
what can be interpreted as the transition from an economy
based on private entrepreneurship to a stock market economy.
In the terminology of the model, stock market assets (or
the technologies underlying these assets) are more capital-intensive
than entrepreneurial assets. This paper studies what happens
to the relative price of nontradable goods (wages) as capital
is shifted from entrepreneurial assets to stock market assets.
Key Findings
- Empirically, there is a nonlinear relationship between
prices and the development of the stock market: Prices
and the stock market increase together in the beginning;
then prices fall as the stock market continues to develop.
- Among
rich countries, the relationship between prices and the
stock market is negative after controlling for per capita
income and using legal origins to control for the endogeneity
of stock market development.
- The development
of the stock market affects real exchange rates via the
relative price of nontradables: Better investment opportunities
increase consumption levels and the price of nontradable
goods (income effect); but if stock market assets are less
labor-intensive than previous entrepreneurial technologies,
prices can fall as the stock market grows because more
labor is available for producing nontradables (substitution
effect.)
Implications
Finding an effect of the stock market on relative prices
can have important repercussions. From the policy standpoint,
it is important that stock market development raises wages
in the beginning. It is a “win-win” situation,
where capitalists and workers increase their welfare (at
least in this model). The decrease in wages that occurs
at some point as the stock market keeps developing may
explain why some countries fail to develop their financial
systems to the maximum or why they fail to eliminate all
regulations. If higher stock market development lowers
wages (that is, workers are able to buy less of the tradable
good), we can expect workers to oppose its development.
How these political considerations determine the actual
level of financial development in a country is an interesting
area of present and future research. In seeking to understand
why small financial systems fail to develop, the simple
answer may be that further financial development may not
be to everyone’s advantage.
Full text of Working
Paper 05-6 
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