Financial markets and growth

The last five years have witnessed a resurgence of interest in the relationship between financial intermediation and economic growth. This issue had been extensively studied nearly two decades earlier by Goldsmith (1969), McKinnon (1973), Shaw (1973) and others, who produced considerable evidence that financial development correlates with growth. But their work, though insightful, lacked analytical foundations. In traditional growth theory, financial intermediation could be related to the level of the capital stock per worker or to the level of productivity, but not to their respective growth rates. The latter were ascribed to exogenous technical progress. The recent revival of interest in the link between financial development and growth stems mainly from the insights and techniques of endogenous growth models, which have shown that there can be self-sustaining growth without exogenous technical progress and that the growth rate can be related to preferences, technology, income distribution and institutional arrangements. This provides the theoretical underpinning that early contributors lacked: tinancial intermediation can be shown to have not only level effects, but also growth effects. The resulting models have offered important insights into the effect of financial development on growth and vice versa. They have also provided new impetus to empirical research on these issues. This paper reviews the ground covered so far on the theoretical and empirical front and points to some still unresolved issues.