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Literature Review: Theories of Economic Growth

Chapter Two

Literature Review

2. 1 Introduction

This section on literature review is subdivided into four subsections. The first part is on the theories of Economic Expansion, the second part is on the theoretical literature showing the relationship between economic progress and financial development, the third part is the empirical review and last but not least the causality is talked about.

2. 2 The Ideas of Economic Growth

In the modern day literature on economic development, the Solow-Swan model (1956) is the key reference point. The above mentioned model is an exogenous development model, i. e. , an economical style of long-run economic expansion place within the construction of neoclassical economics. It will try to make clear long-run economic development set by looking at capital accumulation, labour, or population growth and scientific progress. One of the primary lessons that can be derived from the Solow-Swan model is the need for technological progress to accomplish sustained economic progress.

Although, the Solow-Swan model is a basic point of research, endogenous development theory now provides a overview of the model. We must understand the mechanisms which promotes progress as this can be an important condition for promoting economical growth processes. An important condition is the fact knowledge and technology are developed in interaction with physical capital. Solow model also implies that regardless of the initial per capita stock, all countries will move mutually to the same secure condition and similar standard of moving into the long term.

Over the years, the essential Solow-Swan model has dished up as a base for more technical model. The endogenous expansion theory made an appearance in the 1980s, where Roner (1986) and Lucas (1988) have been important contributors. This theory emphasises that technological progress is an endogenous outcome of an monetary system, not the consequence of forces that come from outside. In addition, this theory revives interest in the long-term economic growth.

2. 3 The Theoretical Books showing the hyperlink between economic growth and financial development

There is an evergrowing body of research (both theoretical and empirical literature) linking financial development and economic expansion. The first research can be traced back to the task of Schumpeter (1911), who suggests that financial market segments has an important part in the growth of the true overall economy. He specifically emphasises the role of the banking sector as an accelerator of economic growth because of its role as a financier of productive investments.

In 1966, Patrick places onward the "supply-leading" theory, where in fact the global development of financial institutions leads to monetary progress and the "demand-following" theory, where financial development develops as the market produces. He also recommended that the relative strengths of the two possible romantic relationships between financial and financial developments varies to a larger intensity through the process of financial expansion: "Before suffered industrial growth gets underway supply-leading may be able to cause real innovation-type investment. As the process of real growth occurs, the supply-leading impetus steadily becomes less important and the demand-following financial response becomes prominent. This sequential process is also likely to appear within and among specific companies or sectors". (Patrick 1966, p. 177). Patrick's analysis can be utilized as a reminder that financial marketplaces and establishments are of interest only due to services they perform, and that the contributions made to financial development is one important factor on which to guage the efficiency of the financial sector, however this was in a roundabout way implied in his work.

It was only in the overdue sixties and early seventies that economists like Goldsmith (1969) and Mckinnon (1973) revived their involvement in the impact of the financial sector, and documented a marriage between development and monetary development. However, most theoretical models based on the aforementioned have evolved after the benefits of the endogenous progress theory. This theory supports that the essential contributors of financial growth are the investment in human being capital, creativity, and knowledge. In addition, it pays particular attention on positive externalities and bubbles over effects of a knowledge-based market that will lead to financial development.

Different channels by which financial homogenisation can encourage economic development in especially developing countries, have been discovered in a variety of theoretical models. A big part of the theoretical literature shows that financial intermediaries can reduce the costs of looking information about businesses and managers, and thus lowering the deal costs (Levine, 1997). Greenwood and Jovanovic (1990) and Levine (1991) have built up models where productive financial markets enhance the quality of investments thus increasing go back and so increasing the speed of economic growth. The model produced by Greenwood and Jovanovic allows brokers of financial intermediation to diversify risk across a variety of high-risk capital investment. Thus, better financial intermediaries can enhance source of information allocation and accelerate growth by providing more accurate information about creation technologies and applying corporate control and so channeling funds to the most profitable purchases. The financial intermediary main job is to channels funds from individuals who have more money or surplus savings (savers) to those who do not have enough money to handle a desired activity (borrowers, investors).

Levine (1997) argued that there are five channels by which the financial sector influences economic progress as given in the physique below:

Figure 2. 1 The Channels Financial Sector Affects Economic Growth


Mobilise savings


Allocate resources


Capital Allocation


Financial sector


Economic Growth


Exert commercial control


Technological Innovation


Ease risk management


Ease trading


The shape shows how financial plans provide five functions that have an impact on saving and allocation decisions, and how these functions effect economic development via capital advancement and know-how. Levine argues that developed countries with better financial set ups tend to experience higher financial growth than growing countries. As countries become richer, the sizes of these currency markets and bank sector would develop much larger. All these would subsequently encourage economic growth through inducing more capital build up and know-how. In general, market frictions like information and business deal costs encourage the introduction of the well-developed financial sector.

Regardless of the developing stage of any economy, financial institutions that allowed cost savings to be invested conveniently and carefully are needed (Meier, 1991). These savings should be channeled in to the most useful purposes. The poorer a country is, the bigger the necessity for intermediaries to collect and spend the cost savings of the populace at large and organizations within its place. Such agencies will allow savings in small amount to be managed and invested to maximise return proficiently, as well as allowing the shareholders to keep liquidity independently, while long-term investment is financed by way of a pooled account collectively.

The monitoring part of the financial intermediaries was examined by Blackburn and Hung (1996). Each and every investor should independently monitor their tasks in the absence of intermediaries and so implying an increased transfer cost. The monitoring task can be entrusted to an intermediary, if the financial sector is developed. This may accelerates economic progress by decreasing costs and a greater proportion of keeping can be apportioned to assets that create know-how. A well-built financial sector has a solid impact on economical development and financial sector development accelerates monetary growth.

There has been a thorough theoretical underpinning with regards to financial development and economical growth but without approaching to an agreement on causal romance between these two phenomena.

2. 4 Empirical Background

Over the past decades there have been a large range of empirical studies that tried out to analyse the qualitative and quantitative effect of financial development on financial development by using different kinds of econometric solutions and a variety of indicators to assess financial development. These studies broadly substantiate that both currency markets and banking sector development have strong positive effect on growth. In addition they support the fact that financial sector development can decrease income inequality: straight through allowing the indegent to get access to financial services, and indirectly through the effect of financial development-led expansion. Most of the empirical studies on finance-growth are based on the supply-leading marriage as assumed by Patrick (1966), as cost savings in the past help the deposition of capital. An index of early empirical works, given by authors, data sets, factors, methods and results is given in Appendix 1.

Early empirical evaluation used standard cross-country linear regressions and found a confident link between money and development after including the lagged value of the financial development variable in the regressions to regulate for simultaneity bias (Goldsmith, 1969; King and Levine, 1993). However, the aforementioned method of estimations does not provide information on the route of causality between finance and growth. Thus the utilization of -panel data techniques is becoming popular. It should be noted that the early trial of the panel data had not been successful as there is uncertainties on the validity of the finance-led expansion hypothesis. However, more recent studies have restored finance as an important source of economic progress. Xu (2003) found confirmation for the finance-led progress theory using multivariate vector car regressions (VAR). After doing Geweke decomposition checks on pooled data of 109 countries, Calderon and Lee (2003) recognise that Xu was right and figured funding generally leads expansion despite some evidence of bidirectional granger causality. Christopoulos and Tsionas (2004) utilize the -panel co integration research to look for the exact causality romance between financial development and economical growth. The results obviously confirm the route of causality result from financial development to monetary progress. Other studies reach different final results on this issue. Demetriades and Hussein (1996) and Kassimatis and Spyrou (2001) find a bi-directional causality result. The results show that while financial development would encourage economical growth, high economical development would promote financial development as high growth countries will often have higher demand for financial services. The effect also implies that the exact design of finance-growth causality varies across countries.

The causality result was further investigated by Gaff (2002). He uncovers that there exist two different empirical relationships other than the bi-directional causality marriage found in identical studies. Firstly, there could be no causative romantic relationship between financial development and economic growth, since monetary growth raises at the same rate as that of financial development. Secondly, financial development may have a poor effect on monetary growth as it may cause financial crises. An evaluation of if the growth aftereffect of financial development is country specific was also carried out. The finance expansion nexus may generally depends on degree of economical development and financial liberalisation.

The upsurge in Gross Local Product (GDP) per capita is the most frequently used way of measuring economic expansion. Levine (1997) uses three different indicators for progress: (1) the common rate of real per capita GDP development; (2) the average rate of expansion in the capital stock per person and (3) total output growth. He detects that GDP per capita development is a good indicator to utilize for analysing economical growth. The methods for financial development change from study to review. Levine in his work introduces four main steps of financial development. These steps are liquid liabilities, claims on the non-financial sector, says on the private sector and deposit bank home credit in comparison to central bank local credit. These represent the scale and activity of the financial sector. Levine also runs regressions including other explanatory factors like log of initial income, institution enrolment rate, inflation, and proportion of exports and imports to GDP.

The major role of the financial sector in financial growth was shown in Levine's studies. His main contribution is the platform of the functions through which financial development can be channeled into monetary growth. He also discloses indirectly that countries with finance institutions which are effective at minimizing information obstacles will enhance financial growth quicker through more investment than countries with less effective financial systems.

The important relationship is also stated by Levine at al. (2002) and the positive effect of the financial sector is backed by Choe and Moosa (1999) in the country specific analysis of South Korea. They use GDP to assess economic progress and family members sector's and the business sector's holdings of securities and the development of the business enterprise sector's loans as financial parameters, and so conclude that financial development contributes to real growth. In addition they discover that financial intermediaries tend to be more important than the administrative centre markets in this cause and impact relationship.

The role of financial development in promoting economic expansion in the Southern Africa Growing Community (SADC), including roughly one half of the Sub-Saharan countries was researched by Allen and Ndikumana (2000). They research the role of the financial sector in detailing the differences in economic benefits in the region. They find some facts for a confident relationship between financial development and the progress of real GDP per capita.

Most studies investigate the partnership between financing and economic development. Johannes et al. (2011) using Johansen approach to co integration evaluation and various other methods of financial development showed that there surely is a positive interactions between financial development and monetary development in the long and short run in Cameroun. An extended run causality romance running from financial development to financial development was also found.

Among the few studies that are based mostly mainly on producing countries, in 2008 Seetanah researched the relationship between financial development and monetary development for the Mauritian market using an autoregressive distributed lag (ARDL) strategy. He shows that financial development has a positive effect on economical development in the long-run and this investment, the degree of openness and the quality of individual capital were significant components of economical development in Mauritius. He finds out that a one percent increase in the liquid liabilities to GDP ratio causes level by 1. 3 percent. The relationship is also substantiated by using home private credit to GDP as the proxy and the outcome level reaches 0. 1 percent. On a single lines, Seetanah, Ramessur & Rojid's (2009) check out a sample of 20 small island economies (including Mauritius) plus they found the lifestyle of an optimistic romantic relationship between financial development and economic growth by using a Generalized Approach to Moments (GMM) powerful panel econometric procedure. Their findings build that financial development has a positive effect on the Mauritian financial output. They also state that financial development shows an optimistic impact on domestic investment levels since financial development enhances output and investments by providing opportunities and information to traders to choose alternative ventures that will increase the allocation of resources. Seetanah (2010) analyses the currency markets development and monetary growth in 27 developing countries (including Mauritius) over a period of 15 years. He used vector automobile regressions (VAR) on -panel data using GMM techniques. The results exhibited that currency markets development is a fundamental element of economic development and also that bank development and currency markets development are complementary. In Nowbutsing, Ramsohok & Ramsohok (2010), an optimistic relationship between methods of financial development and development, but the size of this relationship was found to be nominal.

2. 5 Causality

Previous study has found a positive romance between development of financial sector and economical growth, but there have been debats about the causality of the finance-growth website link. Does economic expansion occurs because of more developed financial sector or does the financial sector improve because of economic growth? That is illustrated in the next diagram.


Capital accumulation / Technological improvement





Financial sector development


Economic growth

Research using cross-sectional data tends to find a causal relationship from financial sector development to economical growth. Ruler and Levine (1993) deduce that higher degrees of financial development are correlated vigorously with faster current and future rates of financial progress, physical capital build up and economical efficiency improvement. They also affirm that the partnership between economic expansion and financial development is not simply a mere accidental relationship, but also that money is very important to economic growth. If economic expansion advances the financial sector, the automobile of expansion must be found elsewhere. Ruler and Levine (1993) and Rousseau and Wachtel (1998) show that the amount of financial development is a satisfactory forecaster of monetary development, however, these results do not solve the issue of causality, since they only study "simultaneous" progress by using average degrees of financial development.

The causality concern was analyzed by Jung (1986) and he confirms that financial development have a bi-directional romantic relationship. He analyzed 56 countries and confirms that the causal path running from financial development to financial growth is more frequently noticed for less developed countries and the in contrast is observed for developed countries. He runs regressions between Gross Local Product (GDP) per capita and the proxies of financial development. Alternatively, Demetriades and Hussain (1996) realize that causality test is more country specific rather than "finance leads growth" or that "finance follows growth".

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