The capital budgeting process in large corporations receives considerable attention by the top management. There are two elements which make the selection of investment projects difficult. First, knowledge about the profitability of different projects is decentralized, as division managers usually have an informational advantage over the firm’s headquarters. Second, when external financing is more costly than internal financing the Headquarters has also to worry about generating internally the cash-flow needed to finance the project.
The choice of exchange rate regime has been an important topic in economic policy and research for a long time. Theoretical and empirical studies have tried to determine whether fixed or flexible exchange rates mitigate financial crises, lower consumption or output volatilities, affect productivity growth or any other important aspects of the performance of countries. The evidence and predictions of these studies are mixed. Some have found that fixed exchange rates are preferable, others exactly the opposite. In terms of the effect of exchange rate regimes on productivity growth, no significant empirical relationship has been found in many of the studies. Among these are Baxter and Stockman (1989) and Gosh, Guilde, and Wolf (2002).
Recently, however, this view has been challenged by Aghion et al. (2006) who performed a panel data study in which they showed that, when a country’s level of financial development is taken into account, the exchange rate regime matters for long-run productivity growth. When the country has a low level of financial development, a flexible exchange rate leads to lower productivity growth than a fixed exchange rate regime, while the effect is insignificant in financially developed countries. These results show that exchange rate regimes and productivity growth can be interrelated and motivate me to explore channels that link the exchange rate regime, the level of financial development, and productivity growth.
Most current theories of the cross-country distribution of per-capita income imply that all countries share the same long-run growth rate (of TFP or per-capita GDP). Yet the historical record shows that growth rates can differ substantially across countries for long periods of time. For example, Pritchett (1997) estimates that the proportional gap in percapita GDP between the richest and poorest countries grew more than five-fold from 1870 to 1990, and according to the tables in Maddison (2001) the proportional gap between the richest group of countries and the poorest grew from 3 in 1820 to 19 in 1998.
The “great divergence” between rich and poor countries continued through the end of the twentieth century. Although many studies2 show that a large group of rich and middle-income countries have been converging to parallel growth paths over the past 50 years or so, the gap between these countries as a whole and the very poorest countries as a whole has continued to widen. For example, the proportional gap in per-capita GDP between Mayer-Foulkes’s (2002) richest and poorest convergence groups grew by a factor of 2.6 between 1960 and 1995, and the proportional gap between Maddison’s richest and poorest groups grew by a factor of 1.75 between 1950 and 1998.
