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We provide a tractable, quantitatively-oriented theory of innovation and technology diffusion to explore the role of international trade in the process of development. We model innovation and diffusion as a process involving the combination of new ideas with insights from other industries or countries. We provide conditions under which each country’s equilibrium frontier of knowledge converges to a Fréchet distribution, and derive a system of differential equations describing the evolution of the scale parameters of these distributions, that is, countries’stocks of knowledge. The model remains tractable with many asymmetric countries and generates a rich set of predictions about how the level and composition of trade affect countries’frontiers of knowledge. We use the framework to quantify the contribution of bilateral trade costs to long-run changes in TFP and individual post-war growth miracles. For our preferred calibration, we find that both gains from trade and the fraction of variation of TFP growth accounted for by changes in trade more than double relative to a model without diffusion.

We quantitatively analyze the role of financial frictions and resource misallocation in explaining development dynamics. Our model economy with financial frictions converges to the new steady state slowly after a reform triggers efficient reallocation of resources; the transition speed is half that of the conventional neoclassical model. Furthermore, in the model economy, investment rates and total factor productivity are initially low and increase over time. We present data from the so-called miracle economies on the evolution of macro aggregates, factor reallocation, and establishment size distribution that support the aggregate and micro-level implications of our theory.

We develop a quantitative framework to explain the relationship between aggregate/sector-level total factor productivity (TFP) and financial development across countries. Financial frictions distort the allocation of capital and entrepreneurial talent across production units, adversely affecting measured productivity. In our model, sectors with larger scales of operation (e.g., manufacturing) have more financing needs, and are hence disproportionately vulnerable to financial frictions. Our quantitative analysis shows that financial frictions account for a substantial part of the observed cross-country differences in output per worker, aggregate TFP, sector-level relative productivity, and capital-to-output ratios.

This paper analyzes the role of specialized high-skilled labor in the disproportionate growth of the service sector. Empirically, the importance of skill-intensive services has risen during a period of increasing relative wages and quantities of high-skilled labor. We develop a theory in which demand shifts toward more skill-intensive output as productivity rises, increasing the importance of market services relative to home production. Consistent with the data, the theory predicts a rising level of skill, skill premium, and relative price of services that is linked to this skill premium.

We take an off-the-shelf model with financial frictions and heterogeneity, and study the mapping from a credit crunch, modeled as a shock to collateral constraints, to simple aggregate wedges. We study three variants of this model that only differ in the form of underlying heterogeneity. We find that in all three model variants a credit crunch shows up as a different wedge: efficiency, investment, and labor wedges. Furthermore, all three model variants have an undistorted Euler equation for the aggregate of firm owners. These results highlight the limitations of using representative agent models to identify sources of business cycle fluctuations.

The purpose of this article is to get mathematicians interested in studying a number of partial differential equations (PDEs) that naturally arise in macroeconomics. These PDEs come from models designed to study some of the most important questions in economics. At the same time, they are highly interesting for mathematicians because their structure is often quite difficult. We present a number of examples of such PDEs, discuss what is known about their properties, and list some open questions for future research.

Two traditional explanations for structural changes are sector-biased technological progress and non-homothetic preferences. This paper integrates both into an otherwise standard growth model and quantitatively evaluates them vis-a-vis time series. The exercise identifies a set of puzzles for standard theories: (i) the model cannot account for the steep decline in manufacturing and rise in services in the later data; (ii) the standard model requires implausibly low elasticity of substitution across goods to match the consumption and output data; and (iii) the behavior of consumption and output shares differs significantly from that of employment shares. We argue that models that incorporate home production, sector-specific factor distortions, and differences across sectors in the accumulation of human capital are promising avenues to amend the standard models.

What is the aggregate and distributional impact of microfinance? To answer this question, we develop a quantitative macroeconomic framework of entrepreneurship and financial frictions in which microfinance is modelled as guaranteed small-size loans. We discipline and validate our model using recent empirical evaluations of small-scale microfinance programs. We find that the long-run general equilibrium impact is substantially different from the short-run effect. In the short-run partial equilibrium, output and capital increase with microfinance but total factor productivity (TFP) falls. In the long run, when general equilibrium effects are considered, as should be for economy-wide microfinance interventions, scaling up microfinance has only a small impact on per-capita income, because an increase in TFP is offset by lower capital accumulation. However, the vast majority of the population benefits from microfinance directly and indirectly. The welfare gains are larger for the poor and the marginal entrepreneurs, although higher interest rates in general equilibrium tilt the gains toward the rich.

Why doesn't capital flow into fast-growing countries? Using a model with heterogeneous producers and underdeveloped domestic financial markets, we explain the joint dynamics of total factor productivity (TFP) and capital flows. When a large-scale economic reform removes preexisting idiosyncratic distortions in a small open economy, its TFP rises, driven by efficient reallocation of economic resources. At the same time, because of the domestic financial frictions, saving rates surge but investment rates respond only with a lag, resulting in capital outflows. The dynamics of TFP, capital flows, and idiosyncratic distortions in the model are consistent with what is observed during growth acceleration episodes, which often follow large-scale economic reforms.

We review both the theoretical and empirical literature on entrepreneurship and financial frictions, with an emphasis on the heterogeneous and dynamic microlevel implications of financial frictions for macrodevelopment.