Academic journal article IUP Journal of Applied Economics

Financial Development as an Instrument of Economic Growth in India: Evidence from Cointegration and Causality Analysis

Academic journal article IUP Journal of Applied Economics

Financial Development as an Instrument of Economic Growth in India: Evidence from Cointegration and Causality Analysis

Article excerpt

(ProQuest: ... denotes formulae omitted.)


The recent financial crisis has drawn global attention to finance and growth relationship and the importance of regulation of financial institutions. Literature on finance and growth nexus provides ambiguous explanations. The theoretical literature started with the pioneering work of Schumpeter (1911), who stated that financial development is important for growth because developed financial structure offers efficient services of financial intermediaries who transfer funds to most innovating entrepreneur. It is now generally accepted that economic growth requires the building up of the financial infrastructure to help in the process of resource mobilization and the effective and efficient deployment of these resources. The financial infrastructure will continue to grow and also diversify in the years to come. It is a necessary concomitant of the process of economic development in which there is growing independence of the saving and investment functions. Gurley and Shaw (1955) realized that economic growth leads to financial development.

Till the late 1960s the role of financial intermediation in general and banks in particular in the process of economic growth of a country was largely ignored. The view on neutrality of financial intermediaries to economic growth came under attack during the late 1960s. Later, it was pointed out that there exists a strong positive correlation between financial development and economic growth of a country. The comprehensive thesis on financial repression was presented by McKinnon (1973) and Shaw (1973). They suggested that the government intervention in the financial market impedes the process of financial development and thus economic growth. This McKinnon-Shaw hypothesis was supported by the endogenous growth literature, (Romer, 1986; Greenwood and Jovanovic, 1990; Barro, 1991 ; Bencivenga and Smith, 1991; King and Levine, 1993; Japelli and Pagano, 1994; and Levine, 1997). But this McKinnon-Shaw hypothesis was criticized by the neo-Keynesians (Diamond, 1983; Singh, 1998 and 2003; and Griffith-Jones, 2003). They stated that financial liberalization impedes economic growth because it leads to crisis rather than stable and efficient functioning of the financial system. Recently, neo-structuralist economists have stated that the financial liberalization model leads to an increase in interest rate and manufacturing cost that consequently impedes economic growth. Subsequently, the proponents of endogenous growth theories argued that with positive marginal productivity of capital, development of financial market induces economic growth in the short as well as long run by improving the efficiency of investment (Bencivenga and Smith, 1991).

Against this backdrop, this paper attempts to trace the relationship between financial development and economic growth in the context of India. The paper is structured as follows: it presents a review of the related literature, followed by discussion of the data and methodology used in the paper. Subsequently, it discusses the results, and finally, offers the conclusion.

Literature Review

There exists a debate whether financial development precedes and plays an active role in economic development or it merely adjusts to the growth of the real sectors. A distinction is drawn between two types of development in relation to the growth of financial infrastructure. These are termed as demand following and supply leading, Under the demand following phenomenon, as trade and industry expand, the financial services needed by them are made available by the financial institutions. Thus the growth of financial institutions is the result of industrial growth, where enterprise expands finance follows. But the supply leading phenomenon is a situation in which the financial development comes into existence first, and by providing the necessary financial services, acts as a stimulant to economic development. …

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