Working Papers, University of California, Department of Economics 10,9
We join the new trade theory with a model of choice between bank and bond financing to show the differential effects of financial policy on the distribution of firm size, welfare, aggregate output, gains from trade, and the real exchange rate in a small open economy. Increasing bank efficiency and reducing bond transaction costs both increase welfare but have opposite effects on the extensive margin of trade, aggregate exports, and the real exchange rate. Increasing the degree of trade openness increases firms' relative demand for bond versus bank financing. We identify a financial switching channel for gains from trade where increasing access to export markets allows firms to overcome high fixed costs of bond issuance to secure a lower marginal cost of capital.