The Financial Development And Economic Growth Economics Essay

Published: Last Edited:

This essay has been submitted by a student. This is not an example of the work written by our professional essay writers.

The objective of this chapter is to provide a theoretical and empirical literature review on financial development and economic growth in general and more narrowly at sectoral growth analysis. Therefore, it is important to determine what financial development relates to, how the financial sector and overall economy are related to each other, and the implications of such a relationship for other sectors of the economy.

In the following of this chapter, the study will first review the theory of financial development, whereby explaining the framework of financial system. The next part will focus on the growth-finance. Further, effects of financial development on various sectors' growth will be discussed. The next section will review the existing empirical studies between financial development and growth (economic, sectors or industries).


2.2.1 Financial Market

(i) Financial System

A financial system is "a network of markets and institutions that bring savers and borrowers together" (Hubbard, 1997). Financial systems have become the keystone of most economies around the world. This field is of great interest to economists, who research mainly the causes and impacts of its development. Through years, economists have revolutionized their perceptive about the nature of relationship that exist between financial system and economic growth. Bagehot (1873) established the pioneering theory on the link relating financial system and economic growth. He found that financial markets facilitate the accumulation of capital and these markets manage the risk from relative investments and business strategies. [1] 

(ii) Functions of Financial System

Levine (1997, 1999), has first depicted this link clearly. Levine demonstrated five main functions of the financial markets that affect the economic growth. More specifically, Levine pointed out that financial system:

Facilitate risk management, hedging, diversifying

Monitor managers and apply corporate control,

Allocate resources,

Mobililize savings, and

Facilitate trading of goods and services.

The schema below highlights the idea of Levine (1999).

Financial markets

& Intermediaries


• Information cost

•Transaction cost


•Facilitating risk management

•Corporate control

•Allocation of resources and provide information

•Mobilization of savings

•Facilitating trade


• Capital Accumulation

• Technological innovations

Economic Growth

Unlike other economists, Levine (1999) produced a comprehensive way of showing the significant role for financial markets. The impact on economic growth occurs through the following channels according to Levine.

Economists had held the view that the development of the financial sector is a crucial element for stimulating economic growth. Financial development can be defined as the ability of a financial sector acquire effectively information, enforce contracts, facilitate transactions and create new incentives for the different types of financial obligations, markets and intermediaries, and all should be at a low cost. [2] Financial development increases the accessibility to financial instruments and institutions which decreases transaction cost and thus channeling funds to efficient investors who are able to invest in both human and physical capital and thereby fostering economic growth. The financial functions or services may influence saving and investment decisions of an economy through capital accumulation and technological innovation and hence economic growth, Levine (1999). Capital accumulation can either be modeled through capital externalities or capital goods produced using constant returns to scale but without the use of any reproducible factors to generate steady-state per capita growth. [3] Through capital accumulation, the functions performed by the financial system affect the steady growth rate thereby influencing the rate of capital formation. The financial system affects capital accumulation either by altering the savings rate or by reallocating savings among different capital producing levels. Through technological innovation, the focus is on the invention of new production processes and goods. [4] As market frictions and laws, regulations and policies differs to a greater extent across economies and over time, the impact of financial development on the economy may have various impacts for resource allocation and welfare in the economy.

2.2.2 Relationship between Financial Development and Economic Growth

(i) Finance Led Growth Theories

In the traditional development economics, there exist two distinct views of the finance-growth nexus. Back in 1911 Joseph Schumpeter argued that financial development induces economic growth. He discussed that through the services that financial intermediaries offer are essential drivers of innovation and growth. Financial intermediaries enable this technological innovation (King, Levine, 1993).

Hicks (1969) also noticed that financial institutions facilitate growth, though he focused on capital formation. Capital formation can be influenced by financial institutions through altering the savings rate or by reallocating savings among different capital producing technologies. According to Hicks the industrial revolution in England was mainly caused by the capital market improvements that moderated liquidity risk (Levine, 1997).

The above general view was also shared by scholars like Goldsmith (1969), McKinnon (1973) and Shaw (1973), who also opted for the practical function of financial services. Goldsmith (1969) assumed that the size of a financial system is linked with the supply and quality of financial intermediation and his analysis on 35 sample countries proved a positive correlation between the financial development and economic growth. MacKinnon (1973) and Shaw (1973) suggested that state involvement in the development of financial systems can be an obstacle for economic growth. This view was further seconded by King and Levine (1993); Pagano (1993); Fry (1995); Zervos and Levine (1996, 1999); Christopoulos (2004); Manoj and Kamat (2007); Hasan, Watchel and Zhou (2008) and Seetanah (2009) where all believed that financial development is a catalyst for economic growth.

(ii) Growth Led Finance Theories

The alternative view suggests that economic growth is the major driving force behind the development of the financial sector. This idea is very much stressed in the work of Robinson (1952). According to him, as an economy grows, more financial institutions, financial products and services emerge in markets in response to a higher demand for financial services. Further, the Patrick's hypothesis (1966) was introduced with the supply leading and demand following, which is important to determine the finance-growth nexus. The demand following view explains the demand for financial services is dependent upon growth and modernization of main sectors. Thus, modern financial institutions, financial assets and liabilities are encouraged in response to the demand of these services by investors in the real economy. Therefore, the more rapid growth of real national income, the greater will be the demand by enterprises for external funds (the savings of others) and therefore financial intermediation. Also, with a given aggregate growth rate, the greater the variance in the growth rates among different sectors or industries, the greater will be the need for financial intermediation to transfer saving from slow-growing industries to fast-growing industries. In this case, an expansion of the financial system is induced because of real economic growth. The next arm of the theory is the supply leading view by. Supply leading has two functions. To transfer resources from the traditional low-growth sector to the modern high-growth sector is first, and secondly, to promote a feasible response among investors in these modern sectors. Thus, financial services from the system stimulate the demand for these services in modern and developing sectors.

(iii) Causal relationship between finance and growth

The development of new theories of endogenous economic growth has given a new scope for financial intermediation in influencing economic performance (Liu, Shu, 2002). Thus, financial markets can have a strong impact on real economic activity. Certainly, Hermes (1994) argues that financial liberalization theory and the new growth theories assume that financial developments lead to economic growth. However, Murinde and Eng (1994), Luintel and Khan (1999) argue that a member of endogenous growth models show the causal relation between financial development and economic growth.

(iv) Link of financial development and real sectors of the economy

The theoretical evidence that financial sector development fosters economic growth has been accumulating over many decades. Schumpeter (1911), McKinnon (1973), Shaw (1973) Goldsmith (1969), Levine (1999) and other proponents came with a clear understanding of the role of financial development on economic growth. However, these theories do not provide a clear explanation of the transmission of financial development to the real sector of the economy that's lead to growth. Recently, some researchers have translated these abstract links between financial development and economic growth into concrete channels, such as household consumption, investment, trade (exports and imports) and government spending. Consequently, any increase from household consumption, investment, trade and government spending will have a positive impact on the real sector of the economy, and on the growth of economies. This link is illustrated below:

Yt= Ct+ It+ (Xt-Mt) + Gt, where

Yt is the gross domestic product, Ct is household consumption, It is domestic investment

Xt is exports, Mt for the imports and Gt is government spending.

Financial development and household expenditure are highly correlated, as discussed in Claessens and Feijen (2006). They argued that despite the causal relationship between financial development and household consumption is less clear than in the case of income, there is evidence that financial development is a leading indicator for increases in household consumption. Apart from increasing the household welfare, financial development also increases investment through the allocation of capital to private sector. The World Business Environment Survey (WBES), recent research concludes that finance is the most important constraint on firm growth. Other studies such as, Rajan and Zingales (1998), Perotti and Volpin (2005) have found that the number of firms in an industry grew faster in counties that have better financial development. Claessens and Feijen (2006) also highlighted that the presence of financial intermediaries with their products such as credit cards, debit cards facilitate domestic and international payment service whereby facilitating trade. The Claessens and Feijen framework hence has demonstrated how financial development and economic growth are related through concrete channels in the economy.