A literature review of thesis topic: “Financial development and Economic growth, evidence of a developing economy”

Literature Review: Financial Development and Economic Growth in Developing Economies

Introduction The relationship between financial development and economic growth has been widely studied in the literature. While some scholars argue that financial development is a catalyst for economic growth, others suggest that it may hinder growth due to potential risks and volatility associated with financial systems. This literature review aims to explore the existing evidence on the relationship between financial development and economic growth in developing economies.

Theoretical Framework The theoretical framework underlying the relationship between financial development and economic growth is based on the notion that financial intermediation promotes economic growth by facilitating savings mobilization, credit allocation, and risk diversification. Financial systems may also contribute to economic growth by improving resource allocation, facilitating technological innovation, and reducing transaction costs. On the other hand, financial systems may hinder economic growth by exposing economies to financial instability, crowding out private investment, and causing inflation.

Empirical Evidence The empirical evidence on the relationship between financial development and economic growth is mixed. Some studies suggest that financial development has a positive effect on economic growth. For instance, Beck et al. (2000) find that financial development promotes economic growth by increasing savings mobilization, improving resource allocation, and reducing transaction costs. Similarly, Levine (2005) argues that financial development contributes to economic growth by enhancing access to credit, improving risk management, and stimulating technological innovation.

However, other studies suggest that the relationship between financial development and economic growth is not always positive. For instance, Rajan and Zingales (1998) find that financial development may hinder economic growth by crowding out private investment, increasing income inequality, and causing inflation. Similarly, Demirgüç-Kunt and Maksimovic (2001) argue that financial development may have a negative impact on economic growth if it leads to financial instability, which can undermine the confidence of investors and increase the risk of systemic crises.

Conclusion In conclusion, the literature on the relationship between financial development and economic growth in developing economies is mixed. While some studies find evidence of a positive relationship between financial development and economic growth, others suggest that this relationship may be negative. Theoretical and empirical evidence suggests that the impact of financial development on economic growth depends on a variety of factors, including the level of financial development, the structure of the financial system, the regulatory environment, and the macroeconomic conditions of the economy. Therefore, further research is needed to fully understand the complex relationship between financial development and economic growth in developing economies.

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