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Literature Review: Theories of Economic Growth

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Chapter Two

Literature Review

2.1 Introduction

This section on literature review is subdivided into four subsections. The first part is on the theories of Economic Growth, the second part is on the theoretical literature showing the relationship between economic growth and financial development, the third part is the empirical review and lastly the causality is discussed.

2.2 The Theories of Economic Growth

In the contemporary literature on economic growth, the Solow-Swan model (1956) is the main reference point. The above model is an exogenous growth model, i.e., an economic model of long-run economic growth set within the framework of neoclassical economics. It tries to explain long-run economic growth set by looking at capital accumulation, labour, or population growth and technological progress. One of the main lessons that can be derived from the Solow-Swan model is the need for technological progress to accomplish sustained economic growth.

Although, the Solow-Swan model is a basic point of reference, endogenous growth theory now provides a review of the model. We must understand the mechanisms which encourages growth as this is an important condition for promoting economic growth processes. An important condition is that knowledge and technology are developed in interaction with physical capital. Solow model also shows that regardless of the initial per capita stock, all countries will move together to the same stable state and similar standard of living in the long run.

Over the years, the basic Solow-Swan model has served as a base for more complex model. The endogenous growth theory appeared in the 1980s, where Roner (1986) and Lucas (1988) have been important contributors. This theory emphasises that technological progress is an endogenous outcome of an economic system, not the result of forces that come from outside. In addition, this theory revives interest in the long-term economic growth.

2.3 The Theoretical Literature showing the link between economic growth and financial development

There is a growing body of research (both theoretical and empirical literature) linking financial development and economic growth. The first investigation can be traced back to the work of Schumpeter (1911), who states that financial markets has an important part in the growth of the real economy. He specifically emphasises the role of the banking sector as an accelerator of economic growth due to its role as a financier of productive investments.

In 1966, Patrick puts forward the “supply-leading” theory, where the global expansion of financial institutions leads to economic growth and the “demand-following” theory, where financial development arises as the economy develops. He also suggested that the relative strengths of the two possible relationships between financial and economic developments may differ to a greater intensity during the process of economic growth: “Before sustained industrial growth gets underway supply-leading may be able to induce real innovation-type investment. As the process of real growth occurs, the supply-leading impetus gradually becomes less important and the demand-following financial response becomes dominant. This sequential process is also likely to occur within and among specific industries or sectors”. (Patrick 1966, p.177). Patrick’s analysis can be used as a reminder that financial markets and institutions are of interest only because of the services they perform, and that the contributions made to economic development is one important factor on which to judge the efficiency of a financial sector, however this was not directly implied in his work.

It was only in the late sixties and early seventies that economists like Goldsmith (1969) and Mckinnon (1973) revived their interest in the influence of the financial sector, and documented a relationship between development and economic growth. However, most theoretical models based on the above have evolved after the introduction of the endogenous growth theory. This theory holds that the vital contributors of economic growth are the investment in human capital, innovation, and knowledge. It also pays particular attention on positive externalities and bubbles over effects of a knowledge-based economy which will lead to economic development.

Different channels through which financial homogenisation can encourage economic growth in especially developing countries, have been identified in various theoretical models. A large part of this theoretical literature shows that financial intermediaries can decrease the costs of searching information about firms and managers, and thus lowering the transaction costs (Levine, 1997). Greenwood and Jovanovic (1990) and Levine (1991) have built up models where efficient financial markets enhance the quality of investments thus increasing return and thus increasing the rate of economic growth. The model developed by Greenwood and Jovanovic allows agents of financial intermediation to diversify risk across a range of risky capital investment. Thus, better financial intermediaries can enhance resource allocation and accelerate growth by providing more accurate information about production technologies and applying corporate control and thus channeling funds to the most profitable investments. The financial intermediary main task is to channels funds from people who have additional money or surplus savings (savers) to those who do not have enough money to carry out a desired activity (borrowers, investors).

Levine (1997) argued that there are five channels through which the financial sector influences economic growth as given in the figure below:

Figure 2.1 The Channels Financial Sector Influences Economic Growth


Mobilise savings



Allocate resources


Capital Allocation


Financial sector



Economic Growth


Exert corporate control



Technological Innovation


Ease risk management


Ease trading


The figure shows how financial arrangements provide five functions that affect saving and allocation decisions, and how these functions influence economic growth via capital innovation and technological innovation. Levine argues that developed countries with better financial structures tend to experience higher economic growth than developing countries. As countries become richer, the sizes of their stock market and banking sector would grow much larger. All these would in turn encourage economic growth through inducing more capital accumulation and technological innovation. In general, market frictions like information and transaction costs encourage the emergence of a well-developed financial sector.

Regardless of the developing stage of an economy, financial institutions that allowed savings to be invested conveniently and safely are required (Meier, 1991). These savings should be channeled into the most useful purposes. The poorer a country is, the bigger the requirement for intermediaries to collect and invest the savings of the population at large and institutions within its territory. Such agencies will allow savings in small amount to be managed and invested to maximise return efficiently, as well as allowing the investors to keep liquidity individually, while long-term investment is financed through a pooled fund collectively.

The monitoring part of the financial intermediaries was studied by Blackburn and Hung (1996). Every single investor should individually monitor their projects in the absence of intermediaries and thus implying a higher transaction cost. The monitoring task can be entrusted to an intermediary, if the financial sector is developed. This will accelerates economic growth by decreasing costs and a greater proportion of saving can be apportioned to investments that create technological innovation. A well-built financial sector has a strong impact on economic growth and financial sector development accelerates economic growth.

There has been a comprehensive theoretical underpinning in relation to financial development and economic growth but without coming to an agreement on causal relationship between these two phenomena.

2.4 Empirical Background

Over the past decades there have been a large number of empirical studies that tried to analyse the qualitative and quantitative effect of financial development on economic growth by using different types of econometric approaches and a variety of indicators to measure financial development. These studies broadly substantiate that both stock market and banking sector development have strong positive effect on growth. They also support the belief that financial sector development can decrease income inequality: directly through allowing the poor to get access to financial services, and indirectly through the effect of financial development-led growth. Most of the empirical studies on finance-growth are based on the supply-leading relationship as assumed by Patrick (1966), as savings in the past help the accumulation of capital. An index of earlier empirical works, specified by authors, data sets, variables, methods and results is given in Appendix 1.

Early empirical analysis used standard cross-country linear regressions and found a positive link between finance and growth after including the lagged value of the financial development variable in the regressions to control for simultaneity bias (Goldsmith, 1969; King and Levine, 1993). However, the above method of estimations does not provide information on the direction of causality between finance and growth. Thus the use of panel data techniques has become popular. It should be noted that the early trial of the panel data was not successful as there was doubts on the validity of the finance-led growth hypothesis. However, more recent studies have restored finance as an important source of economic growth. Xu (2003) found confirmation for the finance-led growth theory using multivariate vector auto regressions (VAR). After conducting Geweke decomposition tests on pooled data of 109 countries, Calderon and Lee (2003) recognise that Xu was right and concluded that finance generally leads growth despite some evidence of bidirectional granger causality. Christopoulos and Tsionas (2004) utilize the panel co integration analysis to determine the exact causality relationship between financial development and economic growth. The results clearly confirm the direction of causality effect from financial development to economic growth. Other studies reach different outcomes on this issue. Demetriades and Hussein (1996) and Kassimatis and Spyrou (2001) find a bi-directional causality effect. The results show that while financial development would encourage economic growth, high economic growth would promote financial development as high growth countries usually have higher demand for financial services. The result also shows that the exact pattern of finance-growth causality may differ across countries.

The causality effect was further researched by Gaff (2002). He reveals that there exist two different empirical relationships other than the bi-directional causality relationship found in identical studies. Firstly, there may be no causative relationship between financial development and economic growth, since economic growth increases at the same rate as that of financial development. Secondly, financial development may have a negative effect on economic growth as it may cause financial crises. An analysis of whether the growth effect of financial development is country specific was also carried out. The finance growth nexus may largely depends on level of economic development and financial liberalisation.

The increase in Gross Domestic Product (GDP) per capita is the most frequently used measure of economic growth. Levine (1997) uses three different indicators for growth: (1) the average rate of real per capita GDP growth; (2) the average rate of growth in the capital stock per person and (3) total productivity growth. He finds that GDP per capita growth is the best indicator to use for analysing economic growth. The measures for financial development vary from study to study. Levine in his work introduces four main measures of financial development. These measures are liquid liabilities, claims on the non-financial sector, claims on the private sector and deposit bank domestic credit compared to central bank domestic credit. These represent the size and activity of the financial sector. Levine also runs regressions including other explanatory variables like log of initial income, school enrolment rate, inflation, and ratio of exports and imports to GDP.

The major role of the financial sector in economic growth was shown in Levine’s findings. His main contribution is the framework of the functions through which financial development can be channeled into economic growth. He also reveals indirectly that countries with financial institutions which are effective at reducing information barriers will enhance economic growth at a faster rate through more investment than countries with less efficient financial systems.

The important relationship is also stated by Levine at al. (2002) and the positive influence of the financial sector is supported by Choe and Moosa (1999) in the country specific study of South Korea. They use GDP to measure economic growth and the household sector’s and the business sector’s holdings of securities and the growth of the business sector’s loans as financial variables, and thus conclude that financial development leads to real growth. They also find that financial intermediaries are more important than the capital markets in this cause and effect relationship.

The role of financial development in promoting economic growth in the Southern Africa Developing Community (SADC), including roughly half of the Sub-Saharan countries was studied by Allen and Ndikumana (2000). They study the role of the financial sector in explaining the differences in economic outcomes in the region. They find some proof for a positive correlation between financial development and the growth of real GDP per capita.

Most studies investigate the relationship between finance and economic growth. Johannes et al. (2011) using Johansen method of co integration analysis and various other measures of financial development demonstrated that there is a positive relationships between financial development and economic growth in the long and short run in Cameroun. A long run causality relationship running from financial development to economic growth was also found.

Among the few researches that are based mainly on developing countries, in 2008 Seetanah studied the relationship between financial development and economic growth for the Mauritian economy using an autoregressive distributed lag (ARDL) approach. He shows that financial development has a positive effect on economic growth in the long-run and that investment, the degree of openness and the quality of human capital were significant elements of economic development in Mauritius. He finds out that a one percent increase in the liquid liabilities to GDP ratio causes level by 1.3 percent. The relationship is also substantiated by using domestic private credit to GDP as the proxy and the output level is at 0.1 percent. On the same line, Seetanah, Ramessur & Rojid’s (2009) investigate a sample of 20 small island economies (including Mauritius) and they found the existence of a positive relationship between financial development and economic growth by using a Generalized Method of Moments (GMM) dynamic panel econometric approach. Their findings establish that financial development has a positive effect on the Mauritian economic output. They also state that financial development shows a positive impact on domestic investment levels since financial development enhances productivity and investments by providing opportunities and information to investors to choose alternative investments that will maximize the allocation of resources. Seetanah (2010) analyses the stock market development and economic growth in 27 developing countries (including Mauritius) over a period of 15 years. He used vector auto regressions (VAR) on panel data using GMM techniques. The results showed that stock market development is a fundamental element of economic growth and also that banking development and stock market development are complementary. In Nowbutsing, Ramsohok & Ramsohok (2010), a positive relationship between measures of financial development and growth, but the size of this relationship was found to be minimal.

2.5 Causality

Previous study has found a positive relationship between development of financial sector and economic growth, but there have been debats about the causality of the finance-growth link. Does economic growth occurs because of more developed financial sector or does the financial sector improve because of economic growth? This is illustrated in the following diagram.

Capital accumulation / Technological improvement




Financial sector development

Economic growth

Research using cross-sectional data tends to find a causal relationship from financial sector development to economic growth. King and Levine (1993) deduce that higher levels of financial development are correlated vigorously with faster current and future rates of economic growth, physical capital accumulation and economic efficiency improvement. They also affirm that the relationship between economic growth and financial development is not just a mere accidental correlation, but also that finance is important for economic growth. If economic growth develops the financial sector, the vehicle of growth must be found elsewhere. King and Levine (1993) and Rousseau and Wachtel (1998) show that the level of financial development is a satisfactory forecaster of economic growth, however, these results do not solve the issue of causality, since they only study “simultaneous” growth by using average levels of financial development.

The causality issue was studied by Jung (1986) and he finds that financial development have a bi-directional relationship. He studied 56 countries and finds that the causal direction running from financial development to economic growth is more frequently observed for less developed countries and the contrary is observed for developed countries. He runs regressions between Gross Domestic Product (GDP) per capita and the proxies of financial development. On the other hand, Demetriades and Hussain (1996) find that causality test is more country specific rather than “finance leads growth” or that “finance follows growth”.

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