Quantifying The Impact Of Financial Development On Economic Development

How important is financial development for economic development? A costly state verification model of financial intermediation is presented to address this question. The model is calibrated to match facts about the U.S. economy, such as intermediation spreads and the firm-size distribution for the years 1974 and 2004. It is then used to study the international data, using cross-country interest-rate spreads and per-capita GDP. The analysis suggests that a country like Uganda could increase its output by 140 to 180 percent if it could adopt the world's best practice in the financial sector. Still, this amounts to only 34 to 40 percent of the gap between Uganda's potential and actual output. Charts and tables.

Abstract: How important is financial development for economic development? A costly state verification model of financial intermediation is presented to address this question. The model is calibrated to match facts about the U.S. economy, such as intermediation spreads and the firm-size distribution for the years 1974 and 2004. It is then used to study the international data, using cross-country interest-rate spreads and per-capita GDP. The analysis suggests a country like Uganda could increase its output by 140 to 180% if it could adopt the world's best practice in the financial sector. Still, this amounts to only 34 to 40% of the gap between Uganda's potential and actual output

This study examines the empirical relationship between financial development and economic growth. The employed data set includes a representative selection of 60 countries over the period 1965-1997. To test the empirical relationship between finance and growth, I have used OLS regressions and three indicators of financial sector development. These indicators measure the financial sector by size (liquid liabilities) and activity (credit provided to the private sector and credit by banks). In accordance to earlier research, the financial sector plays an important part in economic growth as it can reduce the cost of acquiring information, conducting transactions and facilitating savings mobilisation. By providing these services, the financial sector can enhance resource allocation and increase aggregate savings. The study identifies three sets of findings. First, I run regressions by using financial indicators averaged over the period 1965-1997, and I find a positive statistical relationship between financial development and economic growth. The second finding is based on regressions with financial indicators measured in the initial year 1965. These regressions support the first findings, in addition to testing for the long-run effects and checking for causality. While the two first findings are in accordance with earlier studies, the third finding adds to previous research by controlling for the level of economic development. In the last regressions, the sample has been separated into different income groups, interacting with the three financial variables. Financial sector development seems to have at least the same importance in developing countries as in industrialised countries, especially concerning increased credit allocated to the private sector. Credit provided to the private sector seems to follow a path with increased influence associated with a decreased income level, and seems to be important for convergence and a country's economic growth.

Although research shows that financial development accelerates aggregate economic growth, economists have not resolved conflicting theoretical predictions and ongoing policy disputes about the cross-firm distributional effects of financial development. Using cross-industry, cross-country data, the results are consistent with the view that financial development exerts a disproportionately positive effect on small firms. These results have implications for understanding the political economy of financial sector reform.

CD-ROM contains: World Bank data.

This collection of conference papers presents a contemporary insight into key trends impacting on the global financial sector post crisis and highlights new policy and research areas affecting banks and other financial institutions. The four main themes are: financial crises, credit activity, capital markets and risk management.

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