Financial development and economic growth: long‐run equilibrium and transitional dynamics
| DOI | http://doi.org/10.1111/sjpe.12182 |
| Author | Alberto Bucci,Simone Marsiglio |
| Published date | 01 July 2019 |
| Date | 01 July 2019 |
FINANCIAL DEVELOPMENT AND
ECONOMIC GROWTH: LONG-RUN
EQUILIBRIUM AND
TRANSITIONAL DYNAMICS
Alberto Bucci* and Simone Marsiglio**
ABSTRACT
We analyze the impact of financial development on economic growth. Differently
from previous studies that focus mainly on balanced growth path outcomes, we
also analyze the transitional dynamics of our model economy by using a finance-
extended Uzawa–Lucas framework where financial intermediation affects both
human and physical capital accumulation. We show that, under certain rather
general conditions, economic growth may turn out to be non-monotonically
related to financial development (as suggested by the most recent empirical evi-
dence) and that too much finance may be detrimental to growth. We also show
that the degree of financial development may affect the speed of convergence,
which suggests that finance may play a crucial role in determining the length of
the recovery process associated with exogenous shocks. Moreover, in a special
case of the model, we observe that, under a realistic set of parameters, social
welfare decreases with financial development, meaning that even when finance
positively affects economic growth the short-term costs associated with financial
activities more than compensate their long-run benefits.
II
NTRODUCTION
Finance affects the real economy in several ways, hence understanding the
possible mechanisms through which it may impact on economic growth is
essential in order to derive sound policy recommendations (Levine, 2005).
Numerous works emphasize that there may be a nonlinear (Deidda and Fat-
touha, 2002), and ultimately non-monotonic (Allen et al., 2014; Law and
Singh, 2014), relationship between the degree of financial development and
economic performance (i.e., long-run economic growth). Specifically, accord-
ing to some studies, too much finance may be harmful for economic growth,
while at the same time too little finance may be suboptimal. While most of
the works in the field adopt an empirical approach, the number of those
*University of Milan (DEMM); CEIS (University of Rome ‘Tor Vergata’), and RCEA
(Rimini Center for Economic Analysis)
**University of Wollongong
Scottish Journal of Political Economy, DOI: 10.1111/sjpe.12182, Vol. 66, No. 3, July 2019
©2018 Scottish Economic Society.
331
relying on a theoretical methodology is limited. Pagano (1993) was among the
first to emphasize the existence of several channels through which finance
might affect economic growth in a simple Solow-type AK growth model. The
main pathways discussed in his work are related to three fundamental activi-
ties generally run by financial intermediaries, namely funneling savings to
firms, improving the allocation of capital, and affecting an economy’s whole
saving rate. After this seminal work, over the last two decades a number of
studies has focused on the effects of financial intermediaries on human (De
Gregorio, 1996; De Gregorio and Kim, 2000) as well as technological (Mor-
ales, 2003; Trew, 2008) capital accumulation, while only recently some step
further has been made toward considering the role of financial intermediaries
in channeling savings to the most efficient uses
1
(Trew, 2014). Most of the
extant theoretical works on finance and growth suffer from two major limita-
tions, namely they are unable to capture the apparently nonlinear, and possi-
bly non-monotonic, relationship between finance and economic growth and,
moreover, they do not analyze the transitional effects associated with financial
development, as they mainly focus on balanced growth path (BGP) outcomes.
In order to fill these gaps in the literature, we develop a simple extension of
the two-sector Uzawa (1965)-Lucas (1988) growth model to account for the
role and the effects of financial intermediation. We focus on the Lucas-Uzawa
model because this is among the most celebrated and studied endogenous
growth models, because it has frequently been extended along several different
directions
2
and, more importantly, because it is the simplest two-sector
endogenous growth model capable of yielding transitional dynamics in a very
intuitive way. Its versatility allows us to obtain another view on the potential
implications that different degrees of financial development may have on eco-
nomic performance in the short as well as in the long run, via both physical
and human capital accumulation.
Specifically, in our finance-extended Uzawa–Lucas model, financial devel-
opment affects physical capital by altering the amount of resources that
can be potentially allocated to investment purposes (savings funneling chan-
nel), while it also affects human capital via both a productivity and a
depreciation channel. We first analyze the steady-state of our model econ-
omy in the ratio-variables (hence, we characterize its balanced growth solu-
tion in terms of level variables), and then we discuss the transitional
dynamics effects associated with changes in the degree of the economy’s
1
The literature on financial development and economic growth is quickly becoming very
extensive (see, among others, Trew, 2006; Ang, 2008; Arestis et al., 2015, and Valickova
et al., 2015, for insightful surveys), and relatively varied in terms of results obtained, aims
pursued, variables employed, and methodological approaches used. In Section II we review,
as compactly as possible, the main conclusions reached by the latest available empirical liter-
ature, along with some of the possible explanations that the rather few existing theoretical
works on the topic have put forward in order to explain the sign of the effects that finance
may have on economic growth.
2
For example, Bucci and Segre (2011), and Marsiglio and La Torre (2012) analyze, respec-
tively, the growth effects of culture and demographic change within a two sector Lucas-
Uzawa model; La Torre and Marsiglio (2010) propose a three-sector extension of such a
model to allow for endogenous technological progress.
332 ALBERTO BUCCI AND SIMONE MARSIGLIO
Scottish Journal of Political Economy
©2018 Scottish Economic Society
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