Academic journal article European Research Studies

Financial Development and Economic Growth: An Empirical Analysis for the UK

Academic journal article European Research Studies

Financial Development and Economic Growth: An Empirical Analysis for the UK

Article excerpt

1. Introduction

The theoretical relationship between financial development and economic growth goes back to the study of Schumpeter (1911) who focuses on the services provided by financial intermediaries and argues that these are essential for innovation and development.

Schumpeter's (1911) view is that a well functioning financial system would induce technological innovation by identifying, selecting and funding those entrepreneurs who would be expected to successfully implement their products and productive processes.

Robinson (1952, p.86) claims that "where enterprise leads, finance follows"-it is the economic development which creates the demand for financial services and not vice versa. Financial development follows economic growth as a result of increased demand for financial services. This explanation was originally advanced by Friedman and Schwarz (1963).

Theory provides conflicting aspects for the impact of financial development on economic growth. The most empirical studies are based on those theoretical approaches proposed by some different economic school of thoughts which can be divided into three categories: (i) structuralists, (ii) the repressionists, (iii) endogenous growth theory supporters.

The structuralists contend that the quantity and composition of financial variables induces economic growth by directly increasing saving in the form of financial assets, thereby, encouraging capital formation and hence, economic growth (Patrick, 1966; Berthelemy and Varoudakis, 1998).

Patrick (1966) identified two possible causal relationships between financial development and economic growth. The first causal relationship--called 'demand following'--views the demand for financial services as dependent upon the growth of real output and upon the commercialization and modernization of agriculture and other subsistence sectors. Thus, the creation of modern financial institutions, their financial assets and liabilities and related financial services are a response to the demand for these services by investors and savers in the real economy.

The second causal relationship between financial development and economic growth is termed 'supply leading' by Patrick (1966). 'Supply leading' has two functions: to transfer resources from the traditional, low-growth sectors to the modern high-growth sectors and to promote and stimulate an entrepreneurial response in these modern sectors.

This implies that the creation of financial institutions and their services occurs in advance of demand for them. Thus, the availability of financial services stimulates the demand for these services by the entrepreneurs in the modern, growth-inducing sectors. Therefore, the supply--leading hypothesis contends that financial development causes real economic growth, while in contrary to the demand-following hypothesis argues for a reverse causality from real economic growth to financial development.

The financial repressionists, led by, McKinnon (1973) and Shaw (1973) often referred to as the "McKinnon-Shaw" hypothesis contend that financial liberalization in the form of an appropriate rate of return on real cash balances is a vehicle of promoting economic growth. The essential tenet of this hypothesis is that a low or negative real interest rate will discourage saving. This will reduce the availability of loanable funds for investment which in turn, will lower the rate of economic growth. Thus, the "McKinnon--Shaw" model posits that a more liberalized financial system will induce an increase in saving and investment and therefore, promote economic growth.

The Mckinnon--Shaw school examines the impact of government intervention on the development of the financial system. Their main proposition is that government restrictions on the banking system such as interest rate ceilings and direct credit programs have negative effects on the development of the financial sector and, consequently, reduce economic growth. …

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