Finance and Growth: From the Business Cycle to the Long Run

This paper proposes a new methodology to assess the long-run relationship between economic and financial growth. By linking long-run growth to the properties of business cycles, this methodology offers a better understanding of the channels through which finance can impact long-term growth. We first define the direct elasticity between financial and economic growth to measure the contemporaneous effect of financial growth. If financial booms make recessions more severe, losses of growth during recessions are low when compared with growth supplements during expansions. Beyond this contemporaneous effect of financial booms, we identify a persistent effect of financial growth detrimental to subsequent cycles, which is referred as a hysteresis phenomenon. Then, financial and economic growth rates are positively correlated only up to a certain threshold of financial activity. In our panel of economies, the average level of financial activity is well above this threshold, implying that the total elasticity between finance and growth is negative in the long run.