Circuit Theory of Finance and the Role of Incentives in Financial Sector Reform

This paper analyzes the role of the financial system for economic growth and stability, and addresses a number of core policy issues for financial sector reforms in emerging economies. The role of finance is studied in the context of a circuit model with interacting rational, forward- looking, and heterogeneous agents. Finance is shown to essentially complement the price system in coordinating decentralized intertemporal resource allocation choices from agents operating under limited information and incomplete trust. The paper also discusses the links between finance and incentives to efficiency and stability in a circuit context. It assesses the implications for financial sector...