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Financial Development, Financial Fragility, and Growth

  • Norman Loayza
  • Romain Ranciere

This paper attempts to reconcile the apparent contradiction between two strands of the literature on the effects of financial intermediation on economic activity. On the one hand, the empirical growth literature finds a positive effect of financial depth as measured by, for instance, private domestic credit and liquid liabilities (e.g., Levine, Loayza, and Beck 2000). On the other hand, the banking and currency crisis literature finds that monetary aggregates, such as domestic credit, are among the best predictors of crises and their related economic downturns (e.g., Kaminski and Reinhart 1999). This paper starts by illustrating these opposing effects by, first, analyzing the dynamics of output growth and financial intermediation around systemic banking crises and, second, showing that the growth enhancing effects of financial depth are weaker in countries that experienced such crises. After these illustrative exercises, the paper attempts an empirical explanation of the apparently opposing effects of financial intermediation. This explanation is based on a distinction between transitory and trend effects of domestic credit aggregates on economic growth. Working with a panel of cross-country and time-series observations, the paper estimates an encompassing model of long- and short-run effects, following Pesaran, Shin, and Smith (1999)’s Pooled Mean Group Estimator. The main result of the paper is that a positive long-run relationship between financial intermediation and output growth co-exists with a, mostly, negative short-run relationship.

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Paper provided by Central Bank of Chile in its series Working Papers Central Bank of Chile with number 145.

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Date of creation: Feb 2002
Date of revision:
Handle: RePEc:chb:bcchwp:145
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  1. Thorsten Beck & Ross Levine & Norman Loayza, 1999. "Financial Intermediation and Growth: Causality and Causes," Working Papers Central Bank of Chile 56, Central Bank of Chile.
  2. Alejandro Gaytan & Romain Ranciere, 2005. "Banks, Liquidity Crises and Economic Growth," DEGIT Conference Papers c010_040, DEGIT, Dynamics, Economic Growth, and International Trade.
  3. Philippe Aghion & Philippe Bacchetta & Abhijit Banerjee, 2000. "Capital Markets and the Instability of Open Economies," Working Papers 99.01 update, Swiss National Bank, Study Center Gerzensee.
  4. Caprio, Gerard Jr. & Klingebiel, Daniela, 1996. "Bank insolvencies : cross-country experience," Policy Research Working Paper Series 1620, The World Bank.
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  13. Arellano, Manuel & Bond, Stephen, 1991. "Some Tests of Specification for Panel Data: Monte Carlo Evidence and an Application to Employment Equations," Review of Economic Studies, Wiley Blackwell, vol. 58(2), pages 277-97, April.
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  19. Jeremy Greenwood & Boyan Jovanovic, 1989. "Financial Development, Growth, and the Distribution of Income," NBER Working Papers 3189, National Bureau of Economic Research, Inc.
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  37. Asli Demirgüç-Kunt & Enrica Detragiache, 1998. "The Determinants of Banking Crises in Developing and Developed Countries," IMF Staff Papers, Palgrave Macmillan, vol. 45(1), pages 81-109, March.
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  39. Caselli, Francesco & Esquivel, Gerardo & Lefort, Fernando, 1996. " Reopening the Convergence Debate: A New Look at Cross-Country Growth Empirics," Journal of Economic Growth, Springer, vol. 1(3), pages 363-89, September.
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