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debt_equity - DEBT vs EQUITY WHICH ONE IS BETTER FOR...

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1 DEBT vs. EQUITY: WHICH ONE IS BETTER FOR ECONOMIC DEVELOPMENT? HAKAN YILMAZKUDAY While the positive effects of financial depth on economic growth is accepted in the literature, there is still a debate on understanding of how financial markets contribute to the development process. Debt and equity, as different sources of external finance, take their places within this discussion. While some contributions to the theoretical literature takes debt into account (see Greenwood and Jovanovic, 1990; Bencivenga and Smith, 1991; Cooley and Smith, 1998), the others take equity into consideration (see Levine, 1991; Bencivenga, Smith, and Starr, 1994, 1995, 1996). There are only few studies that analyze the effects of both debt and equity on economic development. For instance, Boyd and Smith (1998; BS hereafter), analyze whether debt and equity are substitutes or complements for financing investment. Within this context, they examine how choices among alternative kinds of investment opportunities change as equity markets evolve. Specifically, BS develop a model where capital accumulation is financed by both debt and equity. In their model, investments require external financing, but they are also subject to Costly State Verification (CSV). Investors have access to two investment technologies, one with a return that is only private observable (debt), and the other with a publicly observable return (equity). Assuming plausible parameter
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