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

  • Savings rates

  • Investment decisions

  • Technological innovations

  • Steady-state 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.

Financial systems are also able to mitigate risk associated to individual projects via diversification and CAPM theory. Banks, mutual funds and securities markets provide vehicles for trading, pooling and diversifying risk. Infrastructures that diversify risk via portfolio selections can induce a shift towards higher return projects and thus growth. Furthermore, some of the higher return projects require longer commitments of capital. But savers are often unenthusiastic about relinquishing control of liquidity. Financial systems can help convert between liquid assets and instruments more applicable to long term investments.

Financial institutions also mediate agglomerating capital from savers into investors. Overcoming the transaction costs involved of aggregating saving deposits and ensuring savers are comfortable with relinquishing their...

Buy the full version of these notes or essay plans and more in our Empirical/Contemporary Theories of Economic Growth Notes.