Economic Growth and Financial Development

There are three views about the relation between economic growth and financial development. First, financial development has impact on economic growth (i. e. Bagehot, 1873; Schumpeter, 1912; McKinnon, 1973; Shaw, 1973; Patrick, 1966; Goldsmith, 1969; Fry, 1973). Second, economic growth leads to financial development and that where there is economic growth financial development follows (i. e. Robinson, 1952). The third view, however, contends that both financial development and economic growth Granger cause one another.In the essay, our group focus on the first view which financial development will has passive influence on economic growth. During the year from 1955 to 1993, many scholars has study the relationship between financial development and economic growth. Along with the time goes, the theory that financial development will real promote economic growth has been more and more prefect. In the years between 1950s and 1960s, economists such as Gurley and Shaw began to stress the c redit markets and the importance of financial intermediaries, which they believed play an important role in economy. 5] They argued that tradition monetary transmission mechanism ignores the factor of financial structure and financial flow and only pays attention to the total amount of money and the connection of the output. In 1955, Gurley and Shaw bring up the development of financial institution is both a determined and determining variable in the growth process. (Gurley and Shaw, 1995, p. 532). Gurley and Shaw stressed that financial intermediaries exert influence on credit supply rather than money supply.In this way, financial intermediaries improve the efficiency of savings turning into investments and then affect the whole economic activities. They are the earliest scholars to study in-depth the relationship between financial and economic development in developing countries. Gurley and Shaw pointed out that the main access road of monetary policy transmission probably have di verted from money quantity, which is traditionally thought as the medium of exchange.Whereas, the â€Å"financial capability† of economy would has a closer relationship with the gross expenditure. They put forward financial development enhances the intermediation of loanable funds and therefore growth will be stimulated and they have a debt-intermediation view. The Debt-intermediation view establishes relations between finance and growth. First, economic growth would be associated with financial development, as external indirect finance provides surplus units with the capacity to spend beyond their earnings.Second, growth would stimulate and be stimulated by the â€Å"institutionalisation of saving and investment†; income grows, richer wealth-holders will increase their desire to diversify their asset portfolio. If financial innovation is such to accommodate this â€Å"diversification demand†, financial institutions can enhance their lending capacity and thus bo ost growth; the process becomes a cycle. Gurley and Shaw has earlier pointed that the growing importance of NBFI (non-bank financial intermediaries) when they discussed their activities about potentially serious problems for monetary management and monetary policy. 1] Subsequent analysis of the problems had to two results. [2] First, if the monetary authorities exerted control over the financial system through the operating of the financial markets, monetary management would not be undermined. [3] Second, which placed specific restrictions on banks, at that time the dominant financial entities, the growing role of NBFI was stimulated in part by the opportunities for intermediation created by monetary policy measures.These contributions stressed the relevance for financial â€Å"deepening† (mean financial development) of rising wealth and income, then attempts to control the activities of financial intermediaries. Wealth and income incent the demand for financial services. Res trictions and Controls on financial intermediaries create the stimulation for further financial intermediation by generatingâ€Å"quasi-rents† that risk among participants in financial and capital markets and reflect differences in information. 4] However, Gurley and Shaw do not address the issue of causality between financial development and economic growth. In 1966, Patrick make the causality issue is addressed, he posed theâ€Å"stage of development† hypothesis, where the direction of causality between financial development and economic growth changes over the course of development. [6] Two hypotheses are developed, one is Demand-following hypothesis: a causal relationship from real to finance and the other is Supply-leading hypothesis: a causal relationship from finance to growth.The supply-leading hypothesis supposes a causal relationship from financial development to economic growth, which means mature creation of financial institutions and markets increases the supply of financial services, and thus leads to real economic growth. Patrick suggests that initial development is spurred by supply-leading process, which gives way to demand-following process. He posed financial institutions and services emerge as demand for those services unfolds. The idea is that finance is passive in the growth process, but lack of financial institutions may prevent growth to occur.Financial institutions and their services precede the emergence of demand; government support is needed to finance and nascent modern sector, such as subsidized loans, information to small business and long loan durations. He points out the importance of finance in economic growth. The difficulty of establishing the link between financial development and economic growth was first identified by Patrick (1966), he argued that a higher rate of financial growth is positively correlated with successful real growth. [7] In his theory, commercial banks may issue banknotes and accept â€Å" easy† collaterals. Easy loan† can induce economic growth, for it can finance innovation-type investment, however, in fact it can also induce irresponsible borrowing. Since the important work of Patrick, that first postulated a bi-directional relationship between financial development and economic growth. A large empirical literature has emerged testing this hypothesis as the Patrick's (1966) problem remains unresolved: What is the cause and what is the effect? Is finance a leading sector in economic development, or does it simply follow growth in real output which is generated elsewhere. References: [1] de Oliviera Campos, R. 1964) â€Å"Economic Development and Inflation with Special Reference to Latin America† in Development Plans and Programmes Paris: Organisation for Cooperation and Development [2] Duesenberry, J. S. and M. F. McPherson (1991) â€Å"Monetary Management in Sub-Saharan Africa† HIID Development Discussion Papers no. 369, January [3] Friedm an, M. (1973) Money and Economic Development The Horowitz Lectures of 1972 New York: Praeger Publishers [4] Malcolm F. McPherson and Tzvetana Rakovski (1999) â€Å"Financial Deepening and Investment in Africa: Evidence from Botswana and Mauritius†, Copyright 1999 Malcolm F.McPherson, Tzvetana Rakovski, and President and Fellows of Harvard College [5] Liu Pan Xie Tao (2006) The Monetary Policy Transmission in China-â€Å"Credit Channel† And Its Limitations, Working Papers of the Business Institute Berlin at the Berlin School of Economics (FHW-Berlin) [6] Anthony P. Wood and Roland C. Craigwell Financial Development and Economic Growth: Testing Patrick’s Hypothesis for Three Caribbean Economies [7] Philip Arestis (2005) FINANCIAL LIBERALISATION AND THE RELATIONSHIP BETWEEN FINANCE AND GROWTH, University of Cambridge