The effects of financial development in the short and long run: Theory and evidence from India

Although many view financial access as a means of reducing poverty or increasing growth, empirical studies have produced contradictory results. One problem is that most studies cover only a short time frame and do not consider dynamic effects. I show that introducing credit in a general model of intertemporal consumption creates a boom in consumption and reduces poverty initially, but eventually reduces mean consumption because credit substitutes for precautionary wealth. Using new consistent consumption data that cover a much longer time period than most studies, my empirical findings show that increased access to bank branches in rural India increased consumption initially and reduced poverty, but consumption later fell and poverty rose. The long-term effect is still positive, however, suggesting that credit may have a beneficial role beyond consumption smoothing.