Financial development and economic growth: Some theory and more evidence

Abstract

This study contributes to understanding the role of financial development on economic growth theoretically and empirically. In the theoretical part of the paper, by developing a Solow–Swan growth model augmented with financial markets in the tradition of Wu, Hou, and Cheng (2010), we show that debt from credit markets and equity from stock markets are two long run determinants of GDP per capita. In the empirical part, the long-run relationship is estimated for a panel of 40 countries over the period 1989–2011 by means of Augmented Mean Group (AMG) and Common-Correlated Effects (CCE), both of which allow cross-sectional dependencies. While the cross-sectional findings vary across countries, the panel data analyses reveal that both channels have positive long-run effects on steady-state level of GDP per capita, and the contribution of the credit markets is substantially greater. As a policy implication, we recommend that policy makers place special emphasis on implementing policies that result in the deepening of financial markets, including institutional and legal measures to strengthen creditor and investor rights and contract enforcement. Thus, by fostering the development of a country's financial sector, economic growth will be accelerated.