Financial Innovation and Endogenous Growth∗

We model technological and financial innovation as reflecting the profit maximizing decisions of individuals and explore the implications for economic growth. We start with a Schumpeterian endogenous growth model where entrepreneurs can earn monopoly profits by inventing better goods. Financiers arise to screen potential entrepreneurs. A novel feature of the model is that financiers can engage in the costly and risky process of inventing better processes for screening entrepreneurs. Successful financial innovators screen entrepreneurs better than other financiers, generating monopoly rents. A particular screening process becomes less effective as technology advances. Consequently, technological innovation and economic growth will eventually stop unless financiers innovate. Rather than stressing the level of financial development, we highlight the vital role of financial innovation in supporting economic growth