Financial Development and Economic Growth

Financial Development and Economic Growth

Dimitrios Nikolaou Koumparoulis (Institute of Administrative Management, UK)
DOI: 10.4018/978-1-4666-7470-7.ch003


In this chapter, the author examines the relationship between financial development and economic growth. In the first three sections of the chapter, they present the expansionary policies in the developed countries that led to increased capital flows in the last decades. Such an analysis was done through a thorough review of both empirical and other critical studies from distinguished academics. In the final section, a new financial system at the service of society and development with a case study for Greece is illustrated.
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The Functions Of The Financial System


In a market without imperfections which operates smoothly and no cost there is no need for the financial system, given that trade between surplus and deficit units can be processed “on an automatic” without requiring the existence of an intermediary body.

Financial markets have a peculiarity compared with other markets: goods (money) delivered today exchanged with promises to deliver the goods (money plus interest) at some future time. Thus, the information available to traders is critical because a trader has the ability to affect the outcome in the time between conclusions by the end of the agreement. Moreover, the acquisition of information has a cost, it is costly affair.

The financial system, i.e. financial markets and institutions, exist precisely because there are several shortcomings in the economy. These weaknesses consist in the existence information costs and transaction costs. Thus, the cost required collecting information and the information itself, but also the costs for agreements and transaction processing creates the conditions that highlight the necessity of the financial system.

Financial markets and institutions are in place to minimize the problems created by the lack of adequate information and various imperfections that exist when making transactions. That is, the role of the financial system is to reduce the cost of pumping and cost information to conclude transactions. Different combinations of information costs and transactions that are highlighting the creation of different financial contracts regulations, markets and institutions.

In other words, the financial systems perform a basic function: to improve the allocation of resources in space and time, in the uncertain environment we live. This basic function can be divided into four main categories. Thus, the financial system has to perform four functions as follows:

  • To promote the diffusion, tackling, avoidance of risk,

  • To monitor the management of companies and enterprises to monitor,

  • To mobilize savings, and

  • To facilitate the exchange of goods and services.

But how specific market imperfections justify the emergence of financial markets and intermediaries who offer these five functions? And how they interpret their impact on economic growth?

We can assume that each of the functions of the financial system can affect growth in two ways: through the accumulation of capital and through technological innovations. In the first case, the functions of the financial system affect the growth of the product influencing the rate of creation of capital (e.g. through positive externalities). In the second case, the functions of the financial system affect the growth of the product by increasing the pace of technological innovation, from the discovery of new methods of production and new product introductions.

The sequence of these effects is shown in Figure overleaf and explained in the subsections that follow.

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