Does One Size Fit All?: A Reexamination of the Finance and Growth Relationship

Abstract

The relationship between financial development and economic growth has received a lot of attention in the economic literature in recent years. This literature has generally found that financial development has a strong positive effect on growth. In this paper, we propose that the relationship between financial development and growth may not be uniform, but varies according to the level of financial development of the country. In particular, we hypothesize that there exist three distinct regions of financial development. In the low region (countries with very low levels of financial development), additional improvements in financial markets have an uncertain effect on growth. In the intermediate region, financial development has a large, positive effect on growth. Finally, in the high region, additional financial improvements have a positive, but smaller effect on growth. We examine a panel of 74 countries using GMM dynamic panel techniques and find support for the different regions.