The Influences and Effects of Financial Development on Economic Growth

This study examines the empirical relationship between financial development and economic growth. The employed data set includes a representative selection of 60 countries over the years from 1965-1997. To test the empirical relationship between finance and growth, I have used OLS regressions and three indicators of financial sector development. These indicators measure the financial sector by size (liquid liabilities) and activity (credit provided to private sector and credit by banks). In accordance to earlier research, the financial sector plays an important part in economic growth as it can reduce the cost of acquiring information, conducting transactions and facilitate saving mobilisation. By providing these services, the financial sector can enhance resource allocation and increase aggregate savings. The study identifies three sets of findings. First, I run regressions by using financial indicators averaged over the period 1965-1997, and I find a positive statistical relationship between financial development and economic growth. The second finding is based on regression with financial indicators measured in the initial year 1965. These regressions support the first findings, in addition to test for the long-run effects and check for causality. While the two first findings are in accordance to earlier studies, the third finding adds on to previous research, by controlling for the level of economic development. The results find support of convergence; developing countries grow faster than industrialised countries. In the last regressions, the sample has been separated into different income groups, interacting with the three financial variables. Financial sector developments seem to have at least the same importance in developing countries as in industrialised countries; especially concerning increased credit allocated to private sector. Credit provided to private sector seems to follow a path with an increased influence associated to a decreased income level. So, even though the influence of the financial variables liquid liabilities and credit provided by banking sector are not different among the income groups, credit allocated to private sector seems to be important for convergence and a country's economic growth.