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Financial development and economic growth

  • Aubhik Khan

The author develops a theory of financial development based on the costs associated with the provision of external finance. These costs are assumed to arise within an environment where informational asymmetries between borrowers and lenders are costly to resolve. When borrowing is limited, producers with access to financial intermediary loans obtain higher returns to investment than other producers. This creates incentives for others to undertake the technology adoption necessary to access investment loans. Over time, as increasing numbers of producers gain access to external finance, borrowers' net worth rises relative to debt. This reduces the costs of financial intermediation and raises the overall return on investment. The theory is consistent with recent evidence that financial development reduces the costs associated with the provision of external finance and increases the rate of economic growth. Furthermore, the theory predicts that financial development raises the retu rn on loans and reduces the spread between borrowing and lending rates.

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Paper provided by Federal Reserve Bank of Philadelphia in its series Working Papers with number 99-11.

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Date of creation: 1999
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Handle: RePEc:fip:fedpwp:99-11
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  1. RAFAEL LaPORTA & FLORENCIO LOPEZ-de-SILANES & ANDREI SHLEIFER & ROBERT W. VISHNY, . "Legal Determinants of External Finance,"," CRSP working papers 324, Center for Research in Security Prices, Graduate School of Business, University of Chicago.
  2. Levine, Ross & Loayza, Norman & Beck, Thorsten, 2000. "Financial intermediation and growth: Causality and causes," Journal of Monetary Economics, Elsevier, vol. 46(1), pages 31-77, August.
  3. Bernanke, Ben & Gertler, Mark, 1989. "Agency Costs, Net Worth, and Business Fluctuations," American Economic Review, American Economic Association, vol. 79(1), pages 14-31, March.
  4. Greenwood, Jeremy & Smith, Bruce D., 1997. "Financial markets in development, and the development of financial markets," Journal of Economic Dynamics and Control, Elsevier, vol. 21(1), pages 145-181, January.
  5. Mark Gertler & Simon Gilchrist, 1993. "Monetary policy, business cycles and the behavior of small manufacturing firms," Finance and Economics Discussion Series 93-4, Board of Governors of the Federal Reserve System (U.S.).
  6. Bernanke, B. & Gertler, M. & Gilchrist, S., 1998. "The Financial Accelerator in a Quantitative Business Cycle Framework," Working Papers 98-03, C.V. Starr Center for Applied Economics, New York University.
  7. Greenwood, J. & Jovanovic, B., 1990. "Financial Development, Growth, And The Distribution Of Income," University of Western Ontario, The Centre for the Study of International Economic Relations Working Papers 9002, University of Western Ontario, The Centre for the Study of International Economic Relations.
  8. Asli Demirgüç-Kunt & Vojislav Maksimovic, 1998. "Law, Finance, and Firm Growth," Journal of Finance, American Finance Association, vol. 53(6), pages 2107-2137, December.
  9. Ross Levine, 1997. "Financial Development and Economic Growth: Views and Agenda," Journal of Economic Literature, American Economic Association, vol. 35(2), pages 688-726, June.
  10. Raghuram G. Rajan & Luigi Zingales, 1996. "Financial Dependence and Growth," NBER Working Papers 5758, National Bureau of Economic Research, Inc.
  11. Townsend, Robert M., 1979. "Optimal contracts and competitive markets with costly state verification," Journal of Economic Theory, Elsevier, vol. 21(2), pages 265-293, October.
  12. anonymous, 1998. "Financial intermediation and growth," Economics Update, Federal Reserve Bank of Atlanta, issue Jan, pages 4.
  13. Boyd, John H & Smith, Bruce D, 1994. "How Good Are Standard Debt Contracts? Stochastic versus Nonstochastic Monitoring in a Costly State Verification Environment," The Journal of Business, University of Chicago Press, vol. 67(4), pages 539-61, October.
  14. Ben Bernanke & Mark Gertler, 1987. "Financial Fragility and Economic Performance," NBER Working Papers 2318, National Bureau of Economic Research, Inc.
  15. Udry, Christopher, 1990. "Credit Markets in Northern Nigeria: Credit as Insurance in a Rural Economy," World Bank Economic Review, World Bank Group, vol. 4(3), pages 251-69, September.
  16. Levine, Ross, 1998. "The Legal Environment, Banks, and Long-Run Economic Growth," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 30(3), pages 596-613, August.
  17. Robert M. Townsend, . "Risk and Insurance in Village India," University of Chicago - Population Research Center 91-3a, Chicago - Population Research Center.
  18. repec:fth:wobaco:1083 is not listed on IDEAS
  19. King, Robert G. & Levine, Ross, 1993. "Finance and growth : Schumpeter might be right," Policy Research Working Paper Series 1083, The World Bank.
  20. Gale, Douglas & Hellwig, Martin, 1985. "Incentive-Compatible Debt Contracts: The One-Period Problem," Review of Economic Studies, Wiley Blackwell, vol. 52(4), pages 647-63, October.
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