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The Relationship Between Financial Development and Economic Growth: Insights and Challenges

This paper explores the intricate relationship between financial development (FD) and economic growth, emphasizing that countries with more developed financial systems tend to experience faster growth. It critiques the methodologies used in existing studies, addressing issues like measurement limitations and causality concerns. The authors argue for a deeper understanding of how financial systems can be effectively developed, particularly in developing countries. Key topics include the significance of legal infrastructure, banking system development, and the relationship between trade openness and capital account liberalization.

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The Relationship Between Financial Development and Economic Growth: Insights and Challenges

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  1. Finance and Growth: Is there a relationship? Joanna Rymaszewska & Elizabeth Rivard 8 January 2008 MADE Warsaw University

  2. Remarkably Consistent Results • Countries with better-developed financial systems grow faster • No simultaneity bias between FD and growth • FD eases financial constraints • Local FD matters MADE Warsaw University

  3. Critique • Methodological shortcomings • Measurement issues (depth, turnover ratio-LZ) • Data problems-empirical proxies • Issue of causality remains (KL) • Limited breadth of research (KL, LZ) • Studies do not take into account the market integration • Channels of FD-excluded FDI • Negative effects of FD • Neglect effect on total factor productivity growth MADE Warsaw University

  4. But the real question is... • If financial development is crucial for growth, how can countries develop well-functioning financial systems? • FD is more important for developing countries MADE Warsaw University

  5. How? • Legal infrastructure threshold • Sequencing • Trade openness—capital account liberalisation • Banking system development—equity market development MADE Warsaw University

  6. If finance is indeed so good, why don’t we see more of it? • What causes financial development or a lack of it? MADE Warsaw University

  7. Does financial development cause growth? • We still do not have the smoking gun! MADE Warsaw University

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