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Financial Development And Economic Growth Assignment Economics Essay

A well-developed financial system should help allocate financial resources to the most productive and efficient use. Hence services of the financial intermediaries would make a difference for promoting productivity and innovation within an economy.

The main reason for this paper is to examine the empirical evidence on the impact of financial development on economic growth associated with Latin America. The analysis then shed some lights on the possible mechanisms behind the correlation of financial development and financial growth as theorize by the many growth models.

In the next section, I present a short economical background of Latin America, which is my region of interest followed by a review of the growth theory and some neoclassical growth models. This is followed by an assessment of the general empirical focus on the link between financial development and financial growth in Section 5. A survey of empirical evidence from Latin America follows in section 6 and section 7 concludes.

ABOUT REGION OF INTEREST

Latin America is an economic region within the south of United States of America. It comprises nineteen independent states and Brazil is the leading economy in the bloc. However there are other countries like Argentina, Mexico, Chile, Ecuador, Colombia and Venezuela that cannot be ignored. Latin America is more urbanised than the EU (World Bank, 2011). Approximately 79 % of the populace lives in urban areas. Among the drawbacks of rapid urbanisation is its adverse impact on the environment such as greater pollution, health hazard and decrease in productivity. This study is more worried about the effect on productivity since fundamentally all growth models centres on factor productivity (productivity of capital, labour and technology).

According to latest World Bank published statistics, typically most countries in the Latin American region experienced positive GDP growth within the last 5 years. Argentina grew by 8. 9 % in 2011 (9. 2 % this year 2010); Brazil grew by 2. 7% (7. 5% in 2010 2010); Mexico 3. 9% while Peru's GDP rose by 6. 9% (8. 8% in 2010 2010). Colombia's GDP grew by 5. 9% in 2011 while Chile had a GDP growth of 6. 0% (6. 1% this year 2010).

THEORETICAL BACKGROUND OF GROWTH MODELS AND PROPOSITIONS

Growth models are basically economic models that make an effort to explain how economies grow over time. Accredited to Solow, Harrod and Domar, growth models fittingly fall in two categories namely exogenous and endogenous growth models. Exogenous growth models stipulate that growth is exogenous which long-term growth depends upon factors external to an economy. On the other hand endogenous growth models advocates that long-term growth depends upon factors within the economy or system eg productivity of capital. The Harrod-Domar model can be an exemplory case of an exogenous model that examines the results of fixing capital and labor ratios and savings. Essentially the model highlights the issues of rigidities in the capital-labor ratio and savings rate.

In contrast, Solow models maintain that growth in GDP is explained by productivity increases, technological progress and increased investment. Most economies do not operate at their full potential. Usually there is a gap between the amount of GDP actually produced and the GDP that the economy could produce with full employment and full resource utilization. Because of differences in factor productivity, countries achieve multiple equilibriums.

Neoclassical Growth Theory (Solow model)

This is a theory that underscores that within an economy technological changes have a major influence on economical growth. The idea argues that within an economy, economical growth will not continue unless there are continuous technological advances. Technological progress and other external factors are the primary sources of monetary growth. The model predicts that economies with the same preference and technology to converge to the same level of growth and hence achieve same growth rate. Endogenous growth theory hypothesize that growth is a matter of choice (by households and governments). The huge variations which exist in growth rates between countries and in a country are right down to choices within these countries. The endogenous theory argues that economic growth is generated from within an economy as a direct result of internal processes. Essentially an enhancement of an country's human capital will lead to monetary growth by means of the introduction of new varieties of technology and efficient ways or ways of production. As per the endogenous growth model, Lucas (1988) in a study of US and German, notes that growth increases with effectiveness of investment in human capital and declines with an increase in discount rate.

On the other hand Levacic and Rebmann (1982), highlights that over time, steady state growth rate in an economy is determined by the growth of labour force and technological change. The speed of investment will not determine growth rate within an economy. An increase in the pace of investment is only going to lead to short-term short-term increase in the rate of growth, with the economy reverting to the natural rate of growth when it returns to the steady state. An increase in investment can lead to an increase in the natural rate of growth only when it results in an increase in the underlying technological know-how.

In contrast, exogenous growth theory which assumes that economic growth is mainly determined by external rather than internal factors. How big is the labour force and the progress of technology receive by forces beyond the control of households and governments. According to the belief, given a set amount of labour and technology, economic growth will cease at some point, as current production reaches a state of equilibrium predicated on internal demand factors.

RELATIONSHIP BETWEEN FINANCIAL DEVELOPMENT AND ECONOMIC GROWTH

Schumpeter (1912) is accredited to be the first empirical work attempting to explain the hyperlink between financial development and financial growth. After the pioneering work of Schumpeter, a big amount of theoretical and empirical work has emerged on the role or need for the economic climate in the productivity and growth process (see Goldsmith, 1969; McKinnon, 1973; Shaw, 1973; Galbis, 1977; Greenwood and Jovanovic, 1990; Bencivenga and Smith, 1991; De Gregorio and Guidotti, 1995; King and Levine, 1992; Pagano, 1993). Schumpeter and his colleagues advocate development of financial sector to be able to achieve economical growth. Restrictions on financial intermediation through such measures as interest caps, high reserve requirements and directed credit lending programs tend to impede financial development and hence reduce economic growth.

Differences in a country's financial structure and degree of development influences the direction of its economical development and affects the speed of its monetary growth (Goldsmith 1969), a view also shared by many endogenous growth theory advocates. The development of a country's financial system mirrors the monetary growth of the country. Goldsmith in his earlier empirical work involving the USA, Canada and Europe found that differences in the financial structure had a substantial contributing element in determining rate of growth of real GDP for these countries. The financial structure influenced the amount of the savings and the distribution of savings in a country at a given period. He noted that due to prevailing connection between your level and distribution of capital formation and; the availability of funding to finance the procedure or productivity, the economic climate influences monetary growth through the amount of savings (or credit creation) that is made available to potential entrepreneurs and the supply channels that funding can take.

Other subsequent studies also point in the same direction that financial development and economic growth are obviously related (McKinnon (1973) and; Shaw (1973)) although the channels and even the direction of causality remain empirically and theoretically unclear. Financial deepening is found to encourage savings and reduces constraints on capital accumulation. Financial intermediation increases the economy's allocative efficiency of investment by transferring capital from less productive to more productive sectors (McKinnon, 1973). As a result efficiency and degree of investment rises with the financial development.

More recent compelling evidence is also provided by way of a cross-country study by King and Levine (1993) and; Levine et al. (2000). Evidence from their cross-country studies of 80 countries support the existence of a linkage between your financial system, economical growth and productivity improvements. The results suggest that the level of financial development seem to be always a good predictor of future monetary growth and productivity. The hyperlink of financial development and growth operates through the consequences of investment on growth. The productive capacity of the economy depends upon the quality as well as by the number of investment and capacity utilisation. The financial system plays an important role of proficiently identifying and funding potential productive or viable investment projects in an economy. The easing of credit restrictions on working capital within an economy is expected to increase the efficiency of resource allocation and in so doing decrease the gap between actual and potential output. Thus financial intermediation influences progressive choices of entrepreneurs or simply innovation in an economy which impacts economic growth. The extent of innovation undertaken by entrepreneurs in an economy determines the pace of financial growth. Financial repression on the other hand impedes innovative activity and slows economical growth. Even Levine (2000) concedes that financial development impacts on growth through total factor productivity rather than through capital accumulation or savings rates and concludes that 'maybe Schumpeter was right'.

Financial development as measured by depth or development of financial intermediation is also essential in information and liquidity provision although it may also be detrimental due to its vulnerability to systemic financial crises that are lately common to advertise economies. Levine (1996) contends that stock markets affect growth through liquidity, making investment less risky. Because of the existence of financial markets, companies enjoy perpetual access to capital through liquid equity issues. The final outcome drawn was that currency markets development explains future financial growth.

On the complete, financial intermediaries promote know-how and monetary growth by providing basic services such as mobilization of savings, evaluating and monitoring investment projects, managing and pooling risks, and facilitating transactions. Essentially, the economic climate serves the functions of: provision of information about possible investments; mobilisation and pooling savings and allocation of capital; monitoring investments and assists in embracement of corporate governance principles by investors; facilitates diversification and management of risk and; ease the exchange of goods and services. Weaker corporate governance in the financial system as well impedes effective resource allocation and slows productivity growth.

The financial system through securities markets facilitates rapid advancements and adoption of technological choices and diversification of risk Saint Paul (1992). Accordingly in the lack of technological diversification which is made possible through capital markets there would be no growth convergence a cross similar countries. Consistent with the prediction of endogenous growth model, multiple equilibriums will be experienced. Countries with underdeveloped markets experiencing low equilibrium while developed countries experience high equilibrium. Paul attributes the aforementioned scenario to the growth disparities among countries which is linked to the marginal productivity of factors and the level of financial development and eventually equilibrium output (steady state). His empirical finds hugely contributes supporting evidence associated with the enablement of diversification and management of risk.

Size of Financial System and Economic Development

There is a link between level or size of financial intermediation and financial development. A more substantial financial system allows the exploitation of economies of scale, and therefore leading to better production of information and cost reduction that have a positive impact on economic growth (Greenwood and Jovanovic, 1990: Bencivenga and Smith, 1991). Such a large or well toned economic climate eases credit constraints in an economy. While using easing of credit restrictions, borrowing becomes easier for companies hence it is more likely that profitable investment prospects will never be circumvented because of credit rationing. Furthermore, a large financial system is more effective at allocating capital and monitoring the utilization of funds because of significant economies of scale that are associated with this function. Greater contact with means finance also helps to strengthen the resilience of the economy to external shocks, and smooth out consumption and investment patterns.

FINANCIAL DEVELOPMENT AND ECONOMIC GROWTH: EVIDENCE FROM LATIN AMERICA

There are a number of empirical cross-country studies on the relationship between indicators of financial development and observed rates of growth associated with Latin America. Although generalisation of the leads to the complete Latin American bloc is not clear-cut, however taken together or collectively these different bits of evidence (cross country studies) supports the view that the financial development is important for productivity growth and economical development. What is also evident from these studies is that the validity of the endogeneity and exogeneity of growth would depend on the stage of the country's development and it is country specific.

Evidence from King and Levine (1993) confirm positive correlations between financial development indicators and economic growth indicators. Cross-country studies in Chile and Argentina found a close association between financial sector reforms and financial development in the 70s and 80s in these countries, King and Levine (1993:p. 535). Financial sector reforms significantly correlated with the upsurge in financial development. Ahead of reforms there have been so many restrictions to financial development in the respective financial systems hence suppression of monetary growth. The liberalisation of the financial sectors or reforms in these countries were found to highly correlate with aggregate measures of financial development (financial depth, levels of private credit) and consequently economic growth. Predicated on the empirical results, they concluded that financial development relates to financial growth.

Similarly evidence is found for Honduras and Venezuela by Demetriades and Hussein (1996), linking financial deepening and economic growth. The causality tests involving an example of sixteen developing countries including five Latin American countries (Honduras, Venezuela, Costa Rica, Guatemala and El Salvador) found bi-directional link between financial development and monetary growth. The causality was however found to vary across the countries.

Other empirical findings are equally worth highlighting. Unlike the findings of other researchers, empirical evidence from the eighties found negative correlation between financial development and economical growth in Latin America (Roubini and Sala-i-Martin, 1992). The negative effect is linked to financial repression which is available to be in charge of low economical growth in almost all of the countries. Similar evidence is gathered in De Gregorio and Guidotti (1995) who found slightly divergent results. For a huge cross-country study for almost all of the countries they actually discover that indicators of financial development are positively correlated with monetary growth, suggesting that financial development stimulate growth. But, when the analysis is focused or narrowed down to Latin American alone, they discovered that indicators of financial development are actually negatively correlated with financial growth. The conflicting results are related to the unwanted effects of financial liberalization that was done within an environment that had a poor financial regulation, widespread bank failures and collapsing economies. Interestingly for Latin America, low economic growth was experienced in countries that liberalized quicker, and had rapid growth of credit from the banking system to the private sector. The prevalence of moral hazard perpetrated by the likelihood of state bailout in case of failure and poor financial regulatory environment lead to poor credit allocation and excessive risk taking.

CONCLUSION

This paper surveyed empirical evidence linking financial development and the growth theories. There may be significant empirical evidence linking financial sector development and degrees of growth in Latin American and even in other countries. The study finds sufficient evidence supporting the view that financial development impacts on the productivity and growth of an economy. Essentially, financial development is positively related to monetary growth however the impact varies across countries (De Gregorio and Guidotti, 1992). Aside from the efficiency instead of volume of investment is a key factor in the achievement of growth through financial development. In the long-run only total factor productivity growth is exactly what determinations growth. The faster the productivity growth, faster growth.

The conclusion drawn is partly consistent with both endogenous and exogenous growth models.

Consistent with neoclassical growth models, long-term economic growth depends on the ability to raise the rates of accumulation of physical and human capital, to use the resulting productive assets more efficiently, and to ensure the access of the whole population to these assets.

Financial intermediation supports the investment process by mobilising household and foreign savings for investment by firms; ensuring that these funds are assigned to the most productive use; and spreading risk and providing liquidity so that businesses can operate the new capacity efficiently.

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