Equity Markets and Economic Development: What Do We Know

stock market development on corporate governance. Tying the managers’ income to biased
market prices would result in set of wrong managerial incentives, and ultimately introduce
disturbances in the corporate governance mechanism (Pollin, 2002). Fifth, market cycles tend
to be particularly pronounced in inefficient markets. A lack of reliable information favours
noise and herding behaviours among investors, increasing the probability of sudden opinion
reversals (Singh, 1997). The negative consequences of market volatility are well-known. The
cost of capital to corporations may increase when due to market fluctuations which
discourage risk-averse investors (Caporale, Howells&Soliman, 2004). Major booms and busts
in the secondary market may also undermine the confidence of investors and affect the ability
of companies to raise new funds in the primary market. A major crash in the equity market
may also undermine the financial system as a whole and generate financial crises with very
large economic and social costs (Agénor, 2003). Taken altogether, these intuitions constitute
considerable backing for the idea that informational inefficiencies condition the equity
market’s allocative performance.

(b) Formal implications

Theoreticians have begun to underline the crucial role of informational dynamics in
determining the impact of stock market development on economic growth. A significant
contribution was made in Capasso (2004). The author presented a dynamic general
equilibrium model in which the firm level debt to equity ratio directly depends on the degree
of informational asymmetry, which constitutes an obstacle to switching from debt financing
to a less costly equity financing.

Consider an economy in which capital is produced from risky investment projects whose
expected returns vary according the characteristics of firms. There is a fraction n₁ ∈ (0,1) of
skilled capital producers whose expected return is high, a fraction n₂ ∈ (0,1) of semi-skilled

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