Economic Growth and Financial Development

The relationship between the economic growth of a country and its financial development has in over decades received some considerable attention in the empirical growth study literature. A lot of empirical and theoretical work has greatly emerged from the time of Schumpeter in 1911 and later Solow model in mid 1950s.The two scholar pioneered work that clearly pointed out that  developed financial sector enhances the productivity and economic growth of  a country. Moreover, the theoretical studies revealed that financial intermediaries are highly instrumental in the promoting technological innovations and economic development or growth by ensuring that basic goods and services such as monitoring managerial activities, mobilizes savings , poling risks together, facilitation of transactions  and lastly good evaluation of the investment projects are highly achieved.

Most of the empirical literatures carried out focuses mainly on the functions of macroeconomic stability, income and wealth, ethnic and religious diversities, and financial inequalities and markets imperfections. Among all these factors it has been proven empirically that financial markets are crucial for any economic development and growth. The research work of McKinnon(1973) and Robinson(1952) greatly supported the Schumpeter’s  and Solow models views that states financial sectors promotes the economic growth. They later criticized the financial expressionists and Keynesians advocates in developing countries in the early 1970s.They stated that government restrictions for example taxation, interest rate control and high reserves  demanded by the government, slow down economic growth (Winkler, 1998)

Similarly, they supported the endogenous growth theory literature that stresses the need of having strong financial markets that promotes the economic growth through enhancing investments and ensuring that all resources are channeled to the most productive resources centers. Several economists have strictly emphasized the role of financial markets on economic growth through their empirically carried studies that used panel and cross sectional data. Contrary to that those results based on the time series disagrees there having a positive effect of the financial developments on economic growth (Zhuang, 2009).

According to Badun (2009), differences in the existing financial sectors may lead to institutions characteristics differ in policy implementations. Therefore it’s quite essential to carry out an investigation of financial –economic growth relationship on country to country case basis. This research paper will greatly help to establish the relationship has it has been found that the empirical studies based on the Solow and endogenous growth models has a great potential on the development policy implementation (Jalloh et al, 1997)

The research paper embarks on the developing countries financial sector performance on their economic development. Under this case we select Sierra Leone, a West African country hit by series of war for several decades. In spite of all the war challenges faced the country, it takes pride of having good financial sectors that has greatly influenced the economic growth.However,the country is characterized by having under developed financial institutions and markets which provide inadequate financial resources necessary for any economic growth. Under the structural adjustment programs initiated by the World Bank in 1990s, the country adopted several financial markets reforms in order to provide efficient financial services, promote economic development and to reduce competition within the sector. Although several empirical studies has been carried out  to find out the effect, few studies have progressed to the mature stage of establishing the relationship in sierra Leone .Given the rude mental nature of the financial sectors in sierra Leone, previous studies has failed due to most of them examining single indicators of financial sector development. Thus under this research paper, we combine all the indicators as a matter of complementing each other in  developing up the financial development indices on economic growth (Temple & Nuffield College Oxford, 1995).

Moreover in achieving the objective of the study the paper in sierra Leone explores the autoregressive distributed time lag(ARDL) approach using all the annual data since 1970s to 2008.To meet the positive effects of the relationship, the paper makes an exciting contribution to already existing empirical literature of sierra Leone by employing the Solow and endogenous growth theories models composites index financial markets sector development constructed by the researchers in measuring the relationship between productivity  output and the influencing factors.

Under the discussion part of the papers clearly organized as follows: section 1 provides a short overview of the various financial markets and sectors reforms policies and macroeconomic growth and performance in Sierra Leone. Section 2, will review the empirical and theoretical literature results on the field growth to the economy development. Section 3, will describe briefly the relationship between the related empirical results to the Solow and endogenous growth model and theories. Section 4, involves an analysis themes drawn together from the literature review before conclusion (Davies, 2002).


Brief overview of macroeconomic  growth and performance and financial development in sierra Leone

Just like in many sub Saharan Africa countries financial market sector changes were first adopted  by the government of sierra Leone as from 1990s.The reforms were mainly initiated buy the world banks under the structural adjustment program in 1980s.Factors such as the judicial inadequacy, poor implementation of the policies and financial repressions characterized the financial sector in 1970s and 1980s.During the period the government decided to use the direct administrative controls through the bank of sierra Leone to control interest rates and deposit requirements. Macroeconomic performances began to decline in the mid 1970s and inevitably worsened on 1980s.This led to the GDP growth to be below 3.5 percent in 1970s before declining to 1.5 percent in 1980s.The deterioration was highly attributed to the poor domestic policy implementation and as a result banks were vitally in capable of controlling their loan repayment policies hence high default rates. As a result the real interest in 1987 was as low as negative 60 percent. The financial disintermediation  led savers to hedge all their financial losses against the available investment opportunities  around them still worsening further the liquidity level of the banking sector and eroding all financial sector public confidence (Davies, 2002)

The government had now to adopt the financial sector reforms under the World Bank umbrella leading to a drop of the real interest negative rate from 1990s to 2000.However, despite the reforms, the sector is highly dominated by the retailing banking sectors. Second constrain to the progressive growth of the sector towards boosting economic growth is poor legal frameworks, enforced commercial contracts and political strife. These factors has been found to hinder the potential capability of the sector towards promoting the private sector development .The trend from the world bank data in 2008, reveals that financial sector development led to good economic gradual performance in recent years as follows; real GDP in 2001 was 5.4 percent, 6.3 percent in 2002, 6.5 percent in 2003, then 6.4 in 2007 and lastly in 2008, the economy growth was 5.6 percent. Since then the government has seen the essence to support the financial sector growth through enhancing microfinance services and developing flexible legal frame works as a key root to good economic performance and growth (Seminar on Population Growth and Economic Development et al, 1972)

Theoretical and empirical literature review

Theoretical literature

The relationship literature between the economic growth and the financial development has been the key topic of a lot of debates as appertain to the theoretical and empirical research works. Financial systems have been identified as one of the key instruments that play a vital role in economic growth and development. From the time of Schumpeter in 1911 and recently Shaw (1973), this relationship has been greatly examined. Generally the literature has found to document four man views  on the finance-economic growth nexus ;demand following, supply leading, mutual result of finance and economic growth and lastly those that states that the finance roles in promoting the economic development has been emphasized (Alpha-Kpetewama, 1975).

In 1966, Patrick found two key directions of casual relationship between the financial development and the economic development and growth. These two relationships are supply leading and then demand following. The supply leading nexus reveals that there is a positive impact on the financial development on the economic growth as the more the financial institutions are being created the higher is the supply of financial services to the people and the whole economy hence there is economic growth. The supply leading performs two financial sector service; to transfer all resources from traditional sectors to high growth sectors and lastly to promote the growth of entrepreneurial responses in the modern economic sector. This leads to economic development and growth from the scarce resources being effectively utilized by the investors (Hermes, 1992)

However, the neo -structuralists’ economists led by Taylor and van Wijin bergen in 1980s criticized the theoretical financial liberalization theories created by Solow, Patrick and others by stating that the implementation will slow down the economic growth. In addition to that ,the demand following  states that the causal relationship between financial development and the economic growth was positive due to the high demand of factor elements l such as financial assets and liabilities by the investors and capital savers in the economy. Patrick in 1966 however postulated out that the causal relationship mentioned above varies according to the various development stages available. H e suggested that at the early stage of an economic growth, the supply leading form of financial sector patterns dominates before gradually fading away and thus eventually the demand following pattern takes over. Contrary to that ,Lucas in 1988 rejects the financial economic growth relationship by arguing that economists  should  avoid emphasizing the role of financial sectors in the growth process as sometimes the financial markets acts as the main economic growth impediment creating market volatility and discouraging the potential savers and investors.

Empirical literature

The existing financial development and economic growth reveals that there exists a great difference between countries, financial factors and the causality directions. According to several empirical research findings the supply lading hypothesis has some elements of truth. From 1960-89, the cross sectional empirical method, was heavily relied on in establishing the relationship between the financial development and the economic growth. The measure used mainly involves the use of the liquid liabilities ratio, bank credits ratio and lastly ratio of private credit given to the GDP available. However, the method was found to be subject to data error though it revealed a positive relationship between the two variables (Gregoriou & Gaber, 2006).

Secondly, Odedokun in 1996 used the time series regression analysis empirical method in the analysis of 71 developing states at a different periods from 1960s to 1980s.He found that over 85 percent of the countries had strong financial intermediation that promoted economic growth. Moreover, the research work found out that the financial development –economic growth relationships differs from one country to another. The only weakness found under this empirical method was lack of clear distinction of the variables used (Barro, 1997).

To add on that, Christopher and Tsionas in 2004 conducted the causality study on 10 less developed countries using panel empirical analysis method. The researchers used the ratio of total bank based deposits liabilities to the nominal GDP financial measures of depth before including other control variables such as ratio of investment to GDP and the inflation rates. The results found revealed that there exists a long run causality running between the financial developments and economic growth though no bi directional causality existed (Cline, 2010).

Lastly and no the least, Khan et al in 2005, carried out an investigation of the relationship between the link existing between financial development and economic growth in Pakistan for the period of 1971-2004 using the autoregressive distributed lag empirical approach and found that, financial depth create positive result on the economic growth in long run but no effects in short run. However, the study suffers the weakness of failing to show the magnitude of the strength (Ang, 2009).

Relationship  between the empirical results , the Solow and endogenous growth models and theories

The Solow model is based on the production function Y=F (K, L), where the y= economic output, K= capital L=labor and F =represents the exogenous technological progresses. Financial sector development can be termed as one of the variables in the technological progresses as it explains in long run the growth of income (Rousseau & National Bureau of Economic Research, 2002). This means that the positive relationship between the economic output / growth is directly proportional to the financial development, thus the model postulates that other things kept constant, poor countries like sierra Leone should grow faster than the rich one because the income gap between the poor and the rich keep on converging as standard of living improves (Rousseau et al, 2005)

On the other hand, endogenous growth theory has enhanced the empirical result debate on the relationship between the economic growth and financial development .Since 1990s, the researchers have highly incorporated the financial markets and institutions   in the analysis of various endogenous growth models (Alpha-Kpetewama, 1975). This theory after analysis depict that the financial development relates to the economic development of a country through the technology efficiency and income distribution. As the theory postulates that  the low income countries has low economic growth in reaching their steady state, governments are expected to consider those policies that allows pooling of savings  and capital formation through ensuring growth of productivity (Barro, 1997). Thus when related the results can be boosted through the theory by allowing more funds channeled to the highly productive uses hence efficiency in growth, saving and investments.

Conclusion and policy Recommendation

This paper has empirically and theoretically examined the positive relationship between the financial development and economic growth and performance in Sierra Leone from 1970s to 2008.The empirical methods used above were instrumental in estimating the long and short run relationship of the parameters correlated to the Solow and endogenous growth models. The test and comparison of the empirical results to the theories reveal that a unique co integrating relationship among the real GDP and the financial developments exists. The study has revealed the essentialness of the financial sectors in influencing the performance of Sierra Leone economy and growth. The literature reviews further that the economic development and growth can be agitated through the adoption of both long run and short run a financial policy that promotes the financial sector development (Jalloh et al, 1997)

Therefore, the positive relationship acts as a bench mark for policy makers on the race to enhance economic growth through establishment of various financial institutions   such as credit providers to the private sectors .However, the policy will only be seen through if strong credit policies such as strengthened credit rights and commercial contract laws are imposed (Lee & Heshmati, 2009). Moreover, the Sierra Leone stock exchange will also serve the economy growth well by creating easy avenues to medium and long term based investment finance. However, as this paper has only examined relationship between the financial developments an economic growth in Sierra Leone, any future based research work is openly welcome on exploring the possibility of causality existing between the financial development indices and economic development and growth.

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