Financial Development And Economic Growth Essay

2819 words - 12 pages

Executive summery

This literature review discusses objectives of financial development and economic growth as well as existing relationship of this concept. Financial development is strongly connected with economic situation, but we do not know for sure if this always implies economic growth. There are many factors which influence relationship between financial development and economic growth and its effects such as financial liberalization, government ownership of the banks, monetary policy and rate of inflation, institutional and regulatory framework of financial markets in particular countries. Many researchers are trying to give the right questions and explanations on this ...view middle of the document...

Above all, we can not conclude that financial system and development of this system do not have any impact on economy in whole, but we are not convinced that development of financial system leads to economic growth in every case and every single country. Existing academic research and literature based on this topic carries different opinions and results of this relationship. Although there is a huge research work in this area still there is no final answer and conclusion on this question. Literature review based on this topic shows four main groups of researchers and their opinions. This literature review is structured as an attempt of collecting all these opinions and methodologies which support their claims

2. Literature Review

2.1. Relationship between finance and growth
As previously concluded, theoretical and empirical literature on this topic can be divided into four parts or four conclusions on relationship between financial development and economic growth. First group of researchers and, at the same time, the earliest research work claims that financial development just follows economic growth and there is no impact of financial development on economic growth. In this particular case, economic growth is a result of efficient allocation of resources, physical and human capital, innovations and technologies, so finance, money and financial institutions are there just to provide services which economic subjects need in order to make transactions between themselves. This is often called neoclassical theory of economy which stands that financial system has passive role in economics activities (Levine, 2004). The implications of this opinion can be observed through weaknesses of this analysis such as assumptions of perfect capital markets, constant and equal interest rates so funds which firms and individuals need for their consumption and investments are highly available and the conclusion that economic productivity and efficiency only depends on efficient allocation of resources (Demetriades and Andrianova, 2004). Since real economy does not function in this way, we can not take this theory for granted at least because funding for investments is real important part for every single firm and consumers, especially nowadays when it is really hard to provide funds for investments and consumption.
However, second group of researcher claims that there is existing relationship between financial development and economic growth and that financial development leads to economic growth and prosperity, but that there are implications and obstacles which can make influence on this relationship and retard it. Study of the Demetriades and Law (2004) explains how positive causality between financial development and economic growth is much more presented in countries whose financial system is based on stable and efficient institutions. Undeveloped countries are great evidence for this conclusion, since when institutional infrastructure...

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