FINANCIAL DEVELOPMENT AND ECONOMIC GROWTH : THEORY AND EVIDENCE

Abstract

In this academic exercise, the effects and determinants of financial development on economic growth are being examined. There are several effects: first, financial development can increase the productivity of capital by allocating funds to investment with the highest potential returns; second, induce savings by raising interest rates on financial instruments and assets, adjusted for risk and liquidity; and third, raise the proportion of savings channeled to investment by reducing intermediation costs. The determinants of financial development in an economy are: the income level or wealth attained by the economy to stimulate the financial sector, and public policies that affect the development of the financial sector. Econometric tests are conducted to measure the relationship between financial development and economic growth. The impact of financial development on economic growth is found to be positive and significant. The positive relationship is further illustrated by dividing the sample of sixty-two countries according to their levels of income. It is found that the impact of financial development declines with a move from a lower to a higher income group. The empirical test also shows that countries with a relatively higher levels of financial development tends to have faster economic growth. Notably, the empirical study suggests that the main channel of transmission from financial development to economic growth is the volume of investment. This finding provides an insight to the transmission mechanism of the financial sector. Moving from cross-country level, this study analyzed the causes and effects of financial development in specific case studies. The NIEs, namely, Hong Kong, Singapore, South Korea, and Taiwan are chosen for their distinct difference in the degree of government intervention. The study found that the development of financial sector is dependent on monetary and financial policies. A stable marcoeconomic environment and price stability are particularly important for the financial intermediaries in mobilizing savings and allocating funds. The study suggests that the high saving rates in the NIEs are partly due to financial development, and there is a reduction in intermediation costs due to a more competitive environment implying that more savings are allocated to investment. However, the effects of financial development on the allocative efficiency of the financial system is not clear.