4. To Design Good Policies, Macro Outcomes Need to Be Understood “From the Ground Up” _<mark>Roberto Fattal, Hiau Looi Kee, and Sergio Schmukler</mark>_ Traditionally, macroeconomic outcomes such as growth, economic fluctuations, and reactions to policies and shocks have been studied using aggregate data at the country level. A flurry of new research over the past decade has centered on using micro data at the product, firm, and sector level to shed new light on aggregate outcomes.

# **Macro insights from firm dynamics**

One approach analyzes the macroeconomic implications of firm‐level dynamics and the misallocation of inputs and production across firms.<sup>38</sup> By studying macroeconomic performance as a result of the interaction of individual firms and the surrounding business environment, we have learned how policy distortions at the firm level affect firms’ behavior and lead to worse aggregate outcomes.

One example is the allocation of credit. Traditionally, the effect of financial conditions on economic growth was studied by comparing economic performance across countries with different credit market institutions. Developed financial markets foster prosperity by allocating capital efficiently across the various production possibilities in the economy. Even if the cross‐country comparison could uncover a positive relation between financial development and growth, it would be silent about the mechanism through which such a positive relation works.

The new firm‐level approach to the question proves to be very revealing. Recent research shows that financial markets benefit growth by directly providing credit to firms with good opportunities.<sup>39</sup> Although the overall functioning of financial markets is important, the allocation of credit across firms matters for economy‐wide growth. Small firms as well as young that create novel products and technologies but that lack the financing to scale up tend to be harmed the most by misallocation of credit. In countries where credit is expensive and hard to access, firms typically are small, leading to a misallocation of credit. Large firms that are relatively less productive end up producing a significant share of the output, while smaller more productive firms are unable to grow and to contribute as much as they could. Credit frictions tend to discourage firm entry and creative destruction, leading to poor economic performance.<sup>40</sup> A policy implication is that just developing financial markets might not be enough to generate growth – ensuring that credit flows to the firms that have growth potential is as important.<sup>41</sup> Beyond financial markets, public policy should take into account how different economic agents respond differently to policies. The regulation of entry, for instance, should consider the incentives for low‐scale

> 38 Hsieh, C.T., Klenow, P., 2009, “Misallocation and Manufacturing TFP in China and India.” Quarterly Journal of Economics, 4: 1403‐1448.

> 39 Buera, F., Kaboski, J., Shin, Y., 2011, “Finance and Development: A Tale of Two Sectors.” American Economic Review, 101(5): 1964‐2002.

> 40 Midrigan V., Xu, D., 2014, “Finance and Misallocation: Evidence from Plant‐Level Data,” American Economic Review, 104(2): 422‐58

> 41 Bruhn, M., McKenzie, D., 2014, “Entry Regulation and Formalization of Microenterprises in Developing Countries”, World Bank Research Observer, 29 (2): 186‐201, 2014.

> Didier, T., Levine, R., Llovet, R., Schmukler, S., 2014, “Capital Market Financing and Firm Growth,” Mimeo, World Bank.

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