Post-Keynesian Empirical Research and the Debate on Financial Market Development

Post-Keynesian Empirical Research and the Debate on Financial Market Development

DOI: 10.4018/978-1-4666-6018-2.ch001
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Abstract

Literature suggests that financial intermediation affects growth through various channels. The questions, however, are “Whether financial development affects real economic activities?” and “Does the structure of the financial system matter for the economic growth outcome?” The aim of this chapter is, therefore, to briefly describe the concept of financial market development by highlighting the important role of the financial sector in the development of the real sector. Later in the chapter, the scope of the book is discussed, and research objectives are identified.
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1.1 Why This Topic?

The fundamental question in economic growth that has preoccupied economists is why different economies grow at different rates. The theoretical and empirical literatures have come up with a number of theories and explanations for this, however, most of the early literature considered real sector aspects rather than financial aspects of economic development. Later theoretical and empirical literature revealed that a thorough and effective financial system is essential for economic development and growth. The financial systems are subject to boom and bust cycles which often has consequences for the real economy. Furthermore, the political structure of economies which are repeatedly influenced by preceding experiences plays an important role in shaping the structure and development of the financial system.

So important questions are raised: “What is the role of financial sector in market-based and/or bank-based economies,” “How does financial sector influence the growth process of countries?,” “Does the structure of financial sector matter?.” Such questions were largely ignored in the early growth literature. Nevertheless, there are a few numbers of ground-breaking works in the 60s and 70s which built foundation for the finance-growth nexus. Since 1990s a innovative strand of literature explored relative importance of banks and markets, and introduced the concept of “financial development.” In this book we discuss each in turn.

Since the collapse of fixed exchange rate in the early 1970s, international financial system regimes underwent major changes and transformations, and development finance emerged as a discipline within the general area of economics, which attracted significant theoretical and empirical analyses.

Since the writings of John Stuart Mill in the mid-1800, many economists have argued either that finance is unimportant or that it matters most when it gets out of order (Caprio, 1998). Generations of economists constructed models without money or a financial sector. However, with the explosion of banking and financial crises (such as the 1997 crash and the GFC) around the globe finance is back as an important element in the course of economic development. Over the past thirty years, a great deal of attention has been paid to the role of financial markets in the process of economic growth. The importance of financial markets has been highlighted in the recent literature and financial systems have been recognised via their increasing influence over real sector development.

GFC was another trigger for financial systems to evolve even more substantially. As a result of such evolutionary changes one can borrow greater amounts at cheaper rates than ever before; invest in a multitude of instruments catering to every possible profile of risk and return, and share risks with strangers from across the globe. Technological progress has reduced the cost of communication and computation, as well as the cost engineering techniques from securitisation to credit scoring, is now widely used. Deregulation has removed artificial barriers preventing entry, or competition between products, institutions and markets (Rajan, 2005). Finally, the process of institutional change has created new entities within the financial sector such as private equity firms and hedge funds, as well as new political, legal, and regulatory arrangements.

Before the GFC financial markets had expanded too large uncontrollably and had become much deeper. The broad participation has allowed risks to be more widely spread throughout the economy. The expansion in the variety of intermediaries and financial transactions has major benefits, including reducing the transaction costs of investing, expanding access to capital, allowing more diverse opinions to be expressed in the marketplace, and allowing better risk sharing (Rajan & Zingales, 2003; Shiller, 2003).

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