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Financial frictions have been identified as key factors affecting economic fluctuations and growth. But, can institutional reforms reduce financial frictions? Based on a canonical investment model, the authors consider two potential channels: financial transaction costs at the firm level; and required return at the country level. They empirically investigate the effects of institutions on these financial frictions using a panel of 75,000 firm-years across 48 countries for the period 1990 - 2007. They find that improved corporate governance (e.g., less informational problems) and enhanced contractual enforcement reduce financial frictions, while stronger creditor rights (e.g., lower collateral constraints) are less important.
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