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This chapter outlines both the theoretical and empirical framework of the research, and is based fundamentally on the financial development and economic growth nexus. A few concepts of growth and financial development are discussed to support this research. These concepts formulate the theoretical foundation. The chapter first brushes of an overview of the theory of growth and financial development. Then, a theoretical review based on what pioneers claimed is processed finely. Finally, a special attention is given to the empirical studies on the relationship between financial development and economic growth.
Growth is the subject of any paramount discussion concerning the issue of economics.
Growth entails the expansion of an economy’s productive capacity, its output, its income, and the living standards of its citizens. (Jay Kaplan, 2002)
A general definition of economic growth might read as follows: Economic growth is the increase in per capita real output; it is officially measured by the percentage rate of changes in real GNP per head of the population from one time period to another – normally a year.
Classical growth theory
Adam smith, David Ricardo and Ally young are the evocative of the classical growth theory. The theories’ principal focal point was on the factors of economic growth. Adam Smith (1776) considered his famous theory of division of labour in the subject matter of economic growth. He also delved into breaking down labour into two classes, namely, productive labour and unproductive labour. The rise in labour productivity due to division of labour and the ratio of productive labour in total labour were asserted to be the two determining factors for the growth of a nation. Afterward he affirmed three key factors for economic growth, firstly international trade, secondly low transport cost and thirdly a well-functioning market system.
Harrod-Domar growth model
The grounds of the Harrod-Domar growth theory are saving and investment. Harrod (1939) and Domar (1946) declared that an increase in investment has a two way effect. Investment, on the demand side, boosts aggregate demand which give rise to an increase in national income. On the supply side, investment as well promotes aggregate supply which causes an increase in productivity. Further investment is created once more due to the fact that an increase of productivity leads to more national income. Thus, economic growth is a function of marginal savings rate and capital output ratio. Both of them highlight the major role of capital accumulation in economic growth. Government intervention and macro-economic control were analysed in stimulating economic growth by regulating the amount of savings, foreign capital and ameliorating the capital-output ratio.
Neoclassical growth theory
The neoclassical growth theory initially developed by Solow (1956), also known as the exogenous growth model, outlined a perfect competition economy. The theory depicts a strong positive relationship between financial development and the efficiency of investment. Capital flows from those having a surplus of fund to those who are in deficit but have investment opportunities, hence building up development in the industry. Financial markets collect money from the surplus unit and administer financial support for innovative enterprises, leading to technological change and thus economic growth is boosted.
New growth theory
The provenance of the new growth theory was due to the predictive failure of the neoclassical growth model. Principally developed by Paul Romer (1986), it is an endogenous growth model. International direction is the typical feature of the new growth model. The emphasis of the theory is that economic growth is mainly caused by long run creativity rather than capital accumulation theory as inferred by previous theories. The developer argued that human capital and institutions spur technical renovation and enhance living standards. By mimic existing developed countries that used developed technology, developing countries can attain technology innovation. Nevertheless, Base and Weil (1998) hold that low capital accumulation is a hurdle for developing countries in trying to bring up advanced technology from the developed nations. Developing countries will only experience economic growth if they can increase savings in order to increase capital accumulation.
2.2.2 Overview of Financial development
Markets are indeed imperfect in the reality. There are several costs that are connected to the transaction of goods, services and financial instruments. Moreover there are information asymmetries and this is costly in terms of collecting and processing information about investment opportunities. The market imperfections halt economic development. Due to that, financial contracts, markets and intermediaries were set up.
Financial development is usually defined as a process that marks improvement in quantity, quality, and efficiency of financial intermediary services. This process involves the interaction of many activities and institutions and possibly is associated with economic growth.
The World economic forum defines financial development, in its Financial development report 2011, as the factors, policies, and institutions that lead to effective financial intermediation and markets, as well as deep and broad access to capital and financial services.
Financial development is estimated by determinant such as, access, depth and the efficiency and stability of the financial system. The more widespread the availability of financial services that allow for diversification of risks the greater the degree of financial development.
The definition of financial development is restrained when defining the latter in relation to the degree to which the financial system smooth market imperfections. It, in fact, does not cater much information on the very functions rendered by the financial system to the general economy.
As a result, Levine (2005) and others have came up with widespread definition that mainly stress as a matter of fact on what the financial system does.
Indeed at a broader level, financial development can be defined as upgrading in the quality of five fundamental financial functions namely:
producing and processing information about possible investments opportunities and allocating capital based on these assessments;
monitoring individuals and firms and exerting corporate governance;
easing the trading, diversification, and management of risk;
mobilizing and pooling savings; and
facilitating the exchange of goods, services, and financial instruments.
As per Pagano (1993), financial intermediaries indicate a mechanism by which savings from private households are directed towards investments. Beside the scope of financial intermediaries does not limit itself to the investment channel. Additionally, intermediaries identify and select projects and investment opportunities with the best chances of generating a positive return (Pagano, 1993; King and Levine, 1993a).
Apart from the screening role of financial intermediaries, a further argument for financial intermediaries in promoting innovation is their ability to increase the amount of funding available to risky innovation by holding diversified portfolios (King and Levine, 1993a). This ability neutralizes risk and encourages investment in innovative activities which feed a country’s growth. (*** plz R change)
2.2.3 Review of the relationship between financial development and Economic Growth
*The relationship between financial development and economic growth has received much attention throughout the modern history of economics*. There are three opinions on the relationship between financial development and economic growth. Firstly, finance is an important factor of growth. Secondly, finance is an unimportant element of growth. The third opinion is that finance has a negative impact on growth.
The groundwork on the relationship of financial development and economic growth goes to Schumpeter (1911), Mckinnon (1973) and King and Levine (1993a,b). They are of the first view and professed that financial development, through its determining function of improving the efficiency of intermediation such as reducing transaction cost, information asymmetries and monitoring cost might lead to economic growth.
Schumpeter (1911) is the first protagonist who pioneered that financial institutions are vital for economic growth. He advanced that a well-functioning financial system give rise to technological innovations which subsequently induce economic growth. His work was then followed by various pioneers and finance was given due consideration in the growth matter.
Mckinnon and Shaw (1973) set forth that the growth of real balances drives economic growth. He put emphasis on the relevance of interest rate liberalization in the process of growth. Mckinnon and Shaw (1973) asserted that the process of financial development is the process of the interest rate liberalization. Little by little the interest rate control can be regulated. Banks charge two different rates, one for loan and one for deposit for savings. If the gap between the interest on loan and the interest on savings come to a lower level with the mechanism of financial deepening, this will result to more savings and push up investment as well. Hence, the overall result is economic growth.
In accordance with Creane et al. (2003), the contemporary and dynamic financial system, through its various functions, does contribute to economic growth. The financial system gathers savings from the surplus unit, boosts up investment by investing in favourable investment opportunities, scrutinizes the performance of managers, promotes trading and exchange of goods and services, and manages and diversifies risk. This leads to a more efficient allocation of resources, ultimately accelerated accumulation of both human and physical capital, and rapid technological process, which consecutively flourish economic growth.
The second opinion is more of a skeptical nature concerning the role of financial sector in economic growth. Robinson (1952) argued that financial development follows growth, and articulated this causality argument by suggesting that “where enterprise leads finance follows” (p. 86). Economists like the Nobel Laureate Robert Lucas (1988) ignore the role of financial factors in economic growth. He simply discards finance as playing a major part. A prominent review of 89 pages on development economic written by Nicholas Stern, does not mention finance. At the end of the review Stern (1989) pointed out other factors, not worked on, which may affect economic growth. In these finance was not included.
The third view can be looked at Van Wijnbergen (1983) and Buffie (1984) whereby they criticize the Mckinnon-Shaw school of thought and affirmed that “financial development liberalization is unlikely to raise growth in the presence of efficient curb markets” (p. 12). To add furthermore, Patrick (1966) found a two way relationship and hence claimed bi-directional relationship between financial development and economic growth and Xu (2000) obtained rather mixed evidence.
*Levine (1997) fundamentally analyzes the relationship between efficiency of financial sector of the economy, quality of financial intermediation and economic growth. The overview by Levine relates in major part of description of so-called functional approach. The relationship between quality of functions carried out by financial sector and economic growth is the focal point of this approach. The graph below best illustrates the theoretical framework of finance and growth (Levine 1997, p.691):
Financial Markets, Contracts, Intermediaries.
Channels to Growth:
-exert capital control
-facilitate risk management
-ease trading of goods, services, contracts
The market is not perfect and there is bound to have market frictions such as information costs as well as transaction costs. Thus, these give rise to the need of a financial structure in the economy to take into account of this. The establishment of financial markets had caused an upsurge in the business of intermediaries which transfer funds from the surplus unit to the deficit unit. There are a number of financial functions perform by the institutions of the financial market. The functions exerted channels to growth by the process of capital accumulation and also technological innovation. Both of which are the drivers of growth, thus contributing to growth of wealth of a country.
2.3 EMPIRICAL REVIEW
In the early 20th century the financial development and economic growth nexus can be dated back in time with the work of Joseph Schumpeter and now the link is thoroughly supported.
On the empirical point of view, Goldsmith (1969) is the first one who investigates on the relationship between financial development and economic growth. The study inferred strong and positive relationship between the rate of economic growth and the degree of financial market development.
He devised a sample of 35 countries from 1860 to 1963. To assess financial development, he used the proportion of total assets of financial intermediaries and the yearly GNP. Under the hypothesis that the size of the financial system has a positive correlation with the quantity and quality of financial intermediaries; he came up with a positive relationship between financial development and economic growth.
On the other hand, there were some elementary shortcomings in the research. The analysis incorporates restricted observations on only 35 countries. Moreover * it does not systematically control for other factors influencing growth*. Furthermore the size of financial intermediaries may not precisely assess the functioning of the system. On top of that, he did not consider the causality between financial development and economic growth. His main attention was exclusively the development of bank industry.
Concerning the empirical evidence asserting of the relationship between financial structure and economic growth, King and Levine (1993) triggered the first pursuit toward a more understandable research to resolve the drawbacks of previous studies  . King and Levine (1993) are of the opinion that finance is an essential factor of growth. 77 countries were considered from 1960 to 1989, they evaluate if the level of financial development anticipate economic growth, capital accumulation and productivity growth. They conclude that there exists a positive relationship between financial indicators and growth and that financial development is heavily correlated with subsequent rates of growth, capital accumulation and economic efficiency. They precisely highlight that policies that change the efficiency of financial intermediation exert a first-order influence on growth. *This is a standard implication of models of endogenous growth with financial intermediation.*
However King and Levine (1993) study is subject to limitations. They did not properly deal with the issue of causality while they showed that finance forecasts growth. Moreover although they enhanced upon the measure of financial development, only one segment of the financial system was focused on, that of banks.
Levine et al (2000) made use of a mix of developed and less developed countries, a total of 74 countries, over the years from 1960 to 1995. The authors go further from previous studies and thus distinguished three issues which are of great importance concerning causality. They are, the potential biases induced by simultaneity, omitted variables and unobserved country-specific effect on the link between finance and growth. To deal with those issues, they put forward the use of estimators appropriate for dynamic panels like GMM  , to address simultaneity, along with cross-sectional instrumental variable estimators to derive the exogenous component of financial development.
The two estimation techniques correct for biases and give more accurate estimates. They came up with a strong positive correlation between financial development and growth which can be to a certain extent illustrated by the impact of the exogenous component like finance development on economic growth. The outcomes were illustrated as complementary of the growth-enhancing hypotheses of financial development (Levine et al., 2000). The outcomes are conformed to those presented by Levine (1999). The latter used a sample of 49 countries over the period of 1960-1989 and to obtain that the exogenous components of financial development have a positive impact on economic growth, the GMM procedures were utilized. The conclusion could mean that the direction of the causality runs in both directions between financial development and economic growth.
However, the GMM dynamic panel estimators ignore the integration and cointegration properties of the data. In this way, *it is not clear that the estimated panel models represent a structural long run equilibrium relationship instead of a spurious one*.
Odedokun (1996) studied 71 developing countries in different periods. His findings back up the hypothesis that financial development lead to economic growth. He concluded that financial intermediaries promoted economic growth in around 85 percent countries; financial intermediaries’ role in economic growth is as vital as other factors, for instance export expansion and capital formation rate; the positive effect stand for the most part in developing countries.
Demirguc¸-Kunt and Maksimovic (1998), at the micro-economic point, gauge a financial planning model to determine that financial development promotes the growth of a firm. They selected 30 countries, a mixture of both developed and developing. From firm-level data, they presented that firms having better developed financial system grow rapidly than they could have grown without this access to financial system. In this situation an active stock market and a well-developed legal system are important for the further development of firms.
Christopoulos and Tsionas (2004) examine the long run relationship between financial development and economic growth. Panel unit root tests and panel cointegration analysis were applied in the endeavour of better utilizing the data. The sample consists of 10 developing countries over 30 years namely the period from 1970 to 2000. They have mixed both cross sectional and time series data to depict the finance-growth nexus.
Cross sectional data or time series used by earlier studies is subject to shortcomings such as spurious correlation resulting from non-stationarity, direction of causality not examined and unreliable results if the data is on a short time span. The use of the panel unit root tests and panel cointegration test deduced that there is enough strong evidence in respect of the hypothesis that long run causality runs from financial development to growth. To cope with the problem of endogeneity of regressors, they have used the fully modified OLS estimation to evaluate the cointegrating relation. The result also indicates that there is no short run causality between financial deepening and output; hence the effect is accordingly long run in nature.
To my perspective the approach undertaken by Christopoulos and Tsionas (2004) seems more efficient. The use of panel-based test is significant because the power of standard time-series unit root tests may be considerably low for small sample sizes and time spans frequently feasible in economics. Moreover the panel cointegration tests are used to ensure that test do not undergo loss due to finite samples. The fully modified OLS estimation provides for consistency in the long run relation with the short-run adjustment, cope with the endogeneity problem and respects the properties of the time series data. This methodology withstands the flexibility of the approach of Levine et al. (2000).
The relationship between financial development and economic performance was reviewed more recently by Seetanah et al. (2009) using a sample of 20 island economies over the period of 1980-2002. They made use of both static and dynamic panel data analysis. In line with the literature the static analysis proves that financial development, based on two indicators, have a positive and significant effect on the level of economic growth. In contrast to other explanatory variables such as investment openness and education, the contribution of financial development is regarded to be of lesser degree. The results are supported by the use of generalized method of moment (GMM) dynamic panel estimates.
The panel data regression techniques were used to take into account for country heterogeneity. Furthermore the GMM method was put to use to take into consideration of important dynamics issues. Based on the limitations of using a single equation OLS cross sectional regression model  , panel data technique are recommended.
From my point of view, from the very examination of the relationship between financial development and economic growth by Goldsmith (1969), there has been an upsurge analysis in the field. The studies tried to track the effect of financial development on growth. The empirical research ranges from firm-level industries Demirguc¸-Kunt and Maksimovic, 1998) to individual country analysis (McKinnon, 1973)  , further to cross country analysis (King and Levine, 1993) and even island economies analysis (Seetana et al., 2009). The literature based on practical experience on finance and growth encompass detailed country case studies, industry and firm level studies, time series analyses, cross country growth regressions and panel studies. To my opinion, due to its vast strengths, panel ones are more effective.
At the end of these theoretical and empirical foundations, the analysis will be based on the concepts developed in the course of this chapter. It will be the building of the relationship between financial development and economic growth. Panel unit root tests and panel cointegration analysis strategies will be used to improve the quality of the work due to its pertinence to some pioneering work.
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