Financial Development and Economic Growth the United Term Paper

Financial Development and Economic Growth

The United States of America has made significant developments with respect to their financial market which in turn has resulted in the form of high economic growth. When we compare the U.S., which has one of the most developed financial markets, to other less developed countries, we find that the United States accumulates capital and grow at a higher rate due to markets being more stable. On the other hand, other lesser developed countries have not made much considerable development with respect to financial development which in turn has affected their economic growth. In this paper we will examine the financial development of a less developed country and will measure its effects on its economic growth. For this purpose we will include statistical data to make our point more valid. We will also use measure of financial development such as the exchange rate volatilities, stock market size, bank clearings and the economic growth indicators such as GDP and capital formation data to measure the relationship between financial development and economic growth.

For the purpose of comparing the financial development and economic growth of the U.S., we have chosen the Italian economy and financial system. We will compare the GDP growth rates of both the countries and will measure the level of financial development made by both the markets. Finally we will examine as to whether the economy making higher growth with respect to financial development has made higher economic growth? The reason for choosing Italian economy for comparison is that it is a lesser developed financial market as compared to the United States.

Financial Development and Economic growth - An overview of past studies:

There has been a lot of research already done on the issue of identifying a relationship between financial development and economic growth. The questions like does financial development spurs economic growth? To what extent does higher growth induce a reduction in the incidence of poverty? What can financial development contribute in reducing poverty? are continuously part of the economists debate.

Generally it is believed that Economic growth is simply the result of refraining from current consumption. Within an economy, there are two general types of commodities. One are the consumption goods and the others are the capital goods. The consumption goods are for the purpose of general consumers use while capital goods are used for production of other commodities. When in an economy there is a lesser consumption of consumption goods by the households, a considerable part of the income is not spent and the result is in the form of positive net savings. Because of the saving by the genera households and their abstention from the purchase of consumption goods, more resources become available for investments. Hence, the household sacrifice their current consumption for the sake of their future consumption. From these available resources for investments, firms borrow money for their businesses in order to invest this money in capital goods which will in turn add to capital stock of the nation and provides an opportunity for expanded production. This increase in the production capabilities of the overall economy leads to further growth in the economy of the country. The economic growth models are established on the basis of the assumption that capital accumulation leads to an increase in the growth of the economy. Similarly, economists believe that to accumulate capital, it is necessary to increase savings. That is why most of the economists believe that by increasing the rate of savings, the economy will grow with a relatively faster pace. On the other hand some economists believe that the high rate of savings has not much affect on the long-run equilibrium growth rate. According to them with an increased rate of savings the economy will experience a faster growth rate for a temporary period and the equilibrium growth rate of the economy will remain unchanged. However, they do not mean that the savings are unimportant for economic growth. The reason being that even if the growth rate increases for a temporary period, this period may last for long and the higher savings rate will result in permanently higher levels of capital and output per worker. Therefore, higher rate of savings bring considerable level of improvements in the economy and leads to higher standards of living.

In the recent growth models, technological advancements and growth in population are also being considered as an important factor in the growth of an economy. The assumption being made in this regard is that the capital investment being made in technology or on people will result in the form of positive resources of growth.In other words, investments in technology and people will not only result in the form of improvement in the production capacity of the firm or a particular worker but also will increase the production capacity of the economy as a whole. The result of a positive growth in the production capabilities will be obvious in the increasing returns to scale and this high growth of the economy will be larger than the overall population growth. It may therefore be stated that a high rate of savings may bring a permanent increase in growth in the economy.

When we examine the sophisticated growth models, being introduced recently, we come to the conclusion that the financial markets play a major role in increasing the growth rate of the economy. However, in the past economists have a different view with respect to the relationship of economic growth and financial development. Some of the economists usually argued that financial development can be a major source in bringing economic

Development in the country while others were of the view that economic development itself creates the opportunities for financial development. On the other hand recent views about the relationship between financial and economic development are different. For instance according to Levine (1997) the predominance of theoretical reasoning and practical evidence suggests a positive relationship between financial development and economic growth.

To effectively study the relation between financial development and economic growth we shall examine the progress of the economy from market frictions to growth through the emergence of financial markets. Because of the high costs of obtaining useful and timely information and processing business transactions and other related problems of similar nature being experienced by the businesses, the demand for financial market has risen which has resulted in the form of speedy emergence of financial institutions. In an uncertain economic environment financial systems act as an authentic means for the allocation of resources and to save the investors from unnecessary risks. The basic functions performed by the financial system, such as risk management, ease of trading and effective allocation of resources has a direct impact on the capital accumulation and technological innovation, which in turn affects growth of the economy. (Levine, 1997)

With high information and transactional costs, the demand for financial institutions increases as they tend to ease the trading, hedging, and pooling of risk. Financial institutions arise to supplement secure business transactions and to minimize risks. Because some of the major industrial projects or other high-return projects require a long-run investment of capital, some investors are reluctant to make invest their capital in such projects because they fear to lose control of their savings for a long period, there is a strong need for the presence of financial institutions. In other words we can say that liquidity and economic development are related. In the absence of stable banking institutions, households will refrain from investing their capital and will prefer to hold it in the form of unproductive liquid assets in order to get protection against unpredictable future liquidity needs. This will in turn negatively affect the volume of investments. The ultimate result is that the rate of saving and hence capital accumulation and real growth is lower than what it might have been in case if banks act as a financial agent between investors and the businesses. Thus it can be assumed that a high liquidity risk may lead to lesser investment and lower growth rate.

It has also been observed that financial systems of a country also help reduce individual risk through risk diversification, trading and pooling. Therefore, if risk can be diversified, the investors are more willing to lend their funds to high-return projects that are riskier than low-return projects. In this way the allocation of resources and the rate of savings can be increased.

Another factor to be considered is that it is usually very expensive and complex to evaluate the performances of the business entities and the overall market conditions. Investors usually refrain from getting involved in investment activities where the information available is unreliable and may negatively affect resource allocation or even lead to the wastage of resources. Instead of having each potential investor seeking and paying for information, an intermediary can do it for all of them. Hence, the presence of strong and reliable financial institutions will encourage the savers to invest their saved capital.

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