FACULTY AND RESEARCH

We develop a horizontal R&D growth model to investigate the different channels through which financial reforms affect R&D investment and patent activity. First, a “micro” reform that abolishes barriers-to-entry in the banking sector leads to a decrease in lending rates which stimulates R&D investment and growth. Second, a “macro” reform that removes restrictions on banks’ reserves and credit controls. While this reform increases liquidity, it also increases the risk of default, potentially raising the cost of borrowing. This we dub the “reserves paradox” – this makes banks offset the rise in the default rate with a higher spread between loans and deposit rates. Thus our model suggests that whilst micro reforms boost innovation, macro reforms may appear negative. We find empirical support for these propositions using a sample of 21 OECD countries.