The co‐development of economies and institutions

Abstract In this study, we model the Schumpeterian growth theory in a simple discrete‐time framework in which both economies and institutions need to be developed. Individuals need to borrow from an imperfect financial market to develop an economy. A government can adopt two potential strategies for improving the borrowing capacity of individuals and, as a result, enhancing economic performance: ‘the rule of law’ and ‘industrial policies’. We interpret market‐oriented reform in transition economies as a shift from ‘industrial policies’, exemplified at the extreme by the traditional planned economy, to ‘the rule of law’. The presented model shows that both strategies could be the best choice at different stages of development.