Financial stability is an important goal of policy, but the relation of financial stability to economic performance and even the meaning of the term itself are poorly understood. This paper explores these issues in a theoretical model. We argue that financial instability, or fragility, occurs when entrepreneurs who want to undertake investment projects have low net worth; the heavy reliance on external finance that this implies causes the agency costs of investment to be high. High agency costs in turn lead to low and inefficient investment. Standard policies for fighting financial fragility can be interpreted as transfers that maintain or increase the net worth of potential borrowers.
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