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Relationship Between Finance And Economic Growth Essay Plan Notes

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Finance and Growth

Relationship between financial development and economic growth is a long debated
issue.

Financial instruments, markets and institutions arise to ameliorate the effects of
information, enforcement and transactions costs.

How well financial systems do this influences o o

Investment decisions

o

Technological innovations

o

Savings rates

Steady­state growth rates

Changes in economic activity can influence financial systems with dynamic implications
for growth.

Sample Essay: Financial sector development is not only important for fostering economic growth, but
also for dampening volatility. The availability of external finance is positively associated
with entrepreneurship and innovation. It involves improvements in producing information
about possible investments and allocations of capital; monitoring firms and exerting
corporate governance; trading, diversification and risk management; mobilisation and
pooling of savings; and easing the exchange of goods and services. All of these functions
influence the savings and investment decisions, and technological innovations throughout
the economy, and hence direct economic growth.
Financial intermediaries undertake the costly process of researching investment
possibilities through evaluating firms, managers and market conditions. Individual savers
may not have the ability to collect and process information, and thus do not use capital at
its highest value. Improving resource allocation through the financial sector will therefore
optimise growth.
Principle Agent Problem identifies the divergence between managers and equity holders'
interests. Financial infrastructure allows for arrangements to encourage incorporation, so
that equity holders can ensure corporate governance is exerted effectively. The financial
intermediary, or delegated monitor, economises on aggregate monitoring costs of several
clients and can improve corporate governance whilst reducing credit rationing. High
productivity, capital accumulation and growth ensue as a result.

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