The author argues that the preponderance of theoretical reasoning and empirical evidence suggests a positive first order relationship between financial development and economic growth. There is evidence that the financial development level is a good predictor of future rates of economic growth, capital accumulation, and technological change. Moreover, cross-country, case-style, industry level and firm-level analysis document extensive periods when financial development crucially affects the speed and pattern of economic development. The author explains what the financial system does and how it affects, and is affected by, economic growth. Theory suggests that financial instruments, markets and institutions arise to mitigate the effects of information and transaction costs. A growing literature shows that differences in how well financial systems reduce information and transaction costs influence savings rates, investment decisions, technological innovation, and long-run growth rates. A less developed theoretical literature shows how changes in economic activity can influence financial systems. The author advocates a functional approach to understanding the role of financial systems in economic growth. This approach focuses on the ties between growth and the quality of the functions provided by the financial systems. The author discourages a narrow focus on one financial instrument, or a particular institution. Instead, the author addresses the more comprehensive question: What is the relationship between financial structure and the functioning of the financial system?

/pdf/financial-development-and-economic-growth-views-and-agenda-1isr9l81uu.pdf

Financial development and economic growth : views and agenda

https://pages.stern.nyu.edu/~lpederse/courses/LAP/papers/Information,Fundamental/GlostenMilgrom85.pdf

Bid, ask and transaction prices in a specialist market with heterogeneously informed traders

THE SPHERE of model financial economics encompasses finance, micro investment theory and much of the economics of uncertainty. As is evident from its influence on other branches of economics including public finance, industrial organization and monetary theory, the boundaries of this sphere are both permeable and flexible. The complex interactions of time and uncertainty guarantee intellectual challenge and intrinsic excitement to the study of financial economics. Indeed, the mathematics of the subject contain some of the most interesting applications of probability and optimization theory. But for all its mathematical refinement, the research has nevertheless had a direct and significant influence on practice. ’ It was not always thus. Thirty years ago, finance theory was little more than a collection of anecdotes, rules of thumb, and manipulations of accounting data with an almost exclusive focus on corporate financial management. There is no need in this meeting of the guild to recount the subsequent evolution from this conceptual potpourri to a rigorous economic theory subjected to systematic empirical examination? Nor is there a need on this occasion to document the wide-ranging impact of the research on finance practice.2 I simply note that the conjoining of intrinsic intellectual interest with extrinsic application is a prevailing theme of research in financial economics. The later stages of this successful evolution have however been marked by a substantial accumulation of empirical anomalies; discoveries of theoretical inconsistencies; and a well-founded concern about the statistical power of many of the test methodologies.3 Finance thus finds itself today in the seemingly-paradoxical position of having more questions and empirical puzzles than at the start of its

https://onlinelibrary.wiley.com/doi/pdf/10.1111/j.1540-6261.1987.tb04565.x

A Simple Model of Capital Market Equilibrium with Incomplete Information

https://w4.stern.nyu.edu/finance/docs/WP/2000/pdf/wpa00041.pdf

Illiquidity and stock returns: cross-section and time-series effects $

New tests are presented on the effects of stock illiquidity on stock return. Over time, expected market illiquidity positively affects ex ante stock excess return (usually called â¬Srisk premiumâ¬?). This complements the positive cross-sectional return-illiquidity relationship. The illiquidity measure here is the average daily ratio of absolute stock return to dollar volume, which is easily obtained from daily stock data for long time series in most stock markets. Illiquidity affects more strongly small firms stocks, suggesting an explanation for the changes â¬Ssmall firm effectâ¬? over time. The impact of market illiquidity on stock excess return suggests the existence of illiquidity premium and helps explain the equity premium puzzle.

Illiquidity and Stock Returns: Cross-Section and Time-Series Effects

Asset pricing and the bid-ask spread

http://people.stern.nyu.edu/lpederse/courses/LAP/papers/InventoryRisk/AmihudMendelson80.pdf

Dealership market: Market-making with inventory☆

This paper examines the effects of the mechanism by which securities are traded on their price behavior. We compare the behavior of open-to-open and close-to-close returns on NYSE stocks, given the differences in execution methods applied in the opening and closing transactions. Opening returns are found to exhibit greater dispersion, greater deviations from normality and a more negative and significant autocorrelation pattern than closing returns. We study the effects of the bid-ask spread and the price-adjustment process on the estimated return variances and covariances and discuss the associated biases. We conclude that the trading mechanism has a significant effect on stock price behavior.

Trading Mechanisms and Stock Returns: An Empirical Investigation

We review the theories on how liquidity affects the required returns of capital assets and the empirical studies that test these theories. The theory predicts that both the level of liquidity and liquidity risk are priced, and empirical studies find the effects of liquidity on asset prices to be statistically significant and economically important, controlling for traditional risk measures and asset characteristics. Liquidity-based asset pricing empirically helps explain (1) the cross-section of stock returns, (2) how a reduction in stock liquidity result in a reduction in stock prices and an increase in expected stock returns, (3) the yield differential between on- and off-the-run Treasuries, (4) the yield spreads on corporate bonds, (5) the returns on hedge funds, (6) the valuation of closed-end funds, and (7) the low price of certain hard-to-trade securities relative to more liquid counterparts with identical cash flows, such as restricted stocks or illiquid derivatives. Liquidity can thus play a role in resolving a number of asset pricing puzzles such as the small-firm effect, the equity premium puzzle, and the risk-free rate puzzle.

https://papers.ssrn.com/sol3/Delivery.cfm/SSRN_ID1625020_code1421254.pdf?abstractid=1625020&mirid=5

Liquidity and Asset Prices

The efrect8 of aaaet liquidity on expected retuma for __ ts with infinite maturities (&toc:ka) are eumined for bonda(Treuury notes and bills with matched maturities of lellll than 6 months). The yield to maturity ill higher on notes. which have lower liquidity. The yield di1ferential between notes and billa is a decreuing and convex function of the time to maturity. The results provide a robUlt confirmation of the liquidity effect in auet pricing. THIs PAPER STUDIES EMPIRICALLY the effects of the liquidity of capital assets on their prices. Amihud and Mendelson (1986. 1989) proposed that liquidity affects asset prices because investors require a compensation for bearing transaction costs. Transaction costs-paid whenever the asset is traded-form a sequence of cash outflows. The discounted value of this cost stream proxies for the value 1088 due to illiquidity. which lowers the asset's value for any given cash flow that the asset generates. 1 As a result. the return on assets should be an increasing function of their illiquidity (other things equal). For stocks. the illiquidity effect is expected to be strong because their transaction cost sequence is infinite. Amihud and Mendelson (1986, 1989) demonstrated that common stocks with lower liquidity yielded significantly higher average returns, after controlling for risk and for other factors. These results on the importance of liquidity in the pricing of stocks raise additional questions: (i) does the liquidity effect depend on the specific controls used by Amihud and Mendelson (1986, 1989)1 (ii) does illiquidity have a similarly strong effect on the pricing of bonds. whose maturities are finite? and (iii) if liquidity affects bond yields, how is this effect related to the bond's time to maturity?

https://www.bcuc.com/Documents/Proceedings/2009/DOC_23025_C11-16_JIESC_ARTICLE-JOURNAL-OF-FINANCE.pdf

Haim Mendelson

Papers

Asset pricing and the bid-ask spread

Dealership market: Market-making with inventory☆

Trading Mechanisms and Stock Returns: An Empirical Investigation

Liquidity and Asset Prices

Liquidity, Maturity, and the Yields on U.S. Treasury Securities