Motivation for the Research
The fact that finance can affect real activity is well established by now. In general, the evidence shows that financial arrangements are an important driving force of many real-side phenomena and not just a companion or by-product of the real economy.

This paper explores how stock market development affects cross-country differences in relative prices, also known as the real exchange rate. The real exchange rate is a key variable for making comparisons of the cost of living in different countries and for determining the current account balance.

Research Approach
The author develops a small-open-economy model, estimated by cross-section regression analysis on data from 82 countries, and analyzes its implications to explain the connection between stock market development and relative prices. The model examines what can be interpreted as the transition from an economy based on private entrepreneurship to a stock market economy. In the terminology of the model, stock market assets (or the technologies underlying these assets) are more capital-intensive than entrepreneurial assets. This paper studies what happens to the relative price of nontradable goods (wages) as capital is shifted from entrepreneurial assets to stock market assets.

Key Findings

• Empirically, there is a nonlinear relationship between prices and the development of the stock market: Prices and the stock market increase together in the beginning; then prices fall as the stock market continues to develop.
• Among rich countries, the relationship between prices and the stock market is negative after controlling for per capita income and using legal origins to control for the endogeneity of stock market development.
• The development of the stock market affects real exchange rates via the relative price of nontradables: Better investment opportunities increase consumption levels and the price of nontradable goods (income effect); but if stock market assets are less labor-intensive than previous entrepreneurial technologies, prices can fall as the stock market grows because more labor is available for producing nontradables (substitution effect.)

Implications
Finding an effect of the stock market on relative prices can have important repercussions. From the policy standpoint, it is important that stock market development raises wages in the beginning. It is a "win-win" situation, where capitalists and workers increase their welfare (at least in this model). The decrease in wages that occurs at some point as the stock market keeps developing may explain why some countries fail to develop their financial systems to the maximum or why they fail to eliminate all regulations. If higher stock market development lowers wages (that is, workers are able to buy less of the tradable good), we can expect workers to oppose its development. How these political considerations determine the actual level of financial development in a country is an interesting area of present and future research. In seeking to understand why small financial systems fail to develop, the simple answer may be that further financial development may not be to everyone's advantage.