Survey of Recent Development in the Literature of Financial Market Development and Economic Growth

Survey of Recent Development in the Literature of Financial Market Development and Economic Growth

DOI: 10.4018/978-1-4666-6018-2.ch002
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Abstract

This chapter explores theoretical issues relevant to the history of finance in the literature. The chapter reviews primary research in the areas of economic growth and incorporation of the financial sector that led to the evolutionary process of financial liberalisation and the restructure of financial markets. Different strands of the theory and various schools of thought that (positively) link finance and growth since 1960s are reviewed. Characteristics and rationale behind these schools are debated. Later in the chapter, the theory of financial intermediation that emerged in the New Growth Theory of economic development is discussed and major types of financial market structures including bank-based financial markets and market-based financial markets are distinguished.
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2.2 History Of Finance In The Literature

Finance theory has a surprisingly short history in economics. Economists have long been aware of the basic economic function of credit markets but they were not keen on analysing it much further than that. As such, early ideas about financial markets were largely intuitive, mostly formulated by practitioners. One of the pioneers in the theoretical works was Louis Bachelier (1900), who was basically ignored by theoreticians and practitioners alike. In his 1900 dissertation written in Paris, “Theorie de la Speculation” (and in his following works, 1906, and 1913), he predicted much of what was to become standard issue in financial theory: random walk of financial market prices, Brownian motion and martingales.

Fisher (1906, 1907, 1930) had highlighted the basic functions of credit markets for economic activity, specifically as a way of allocating resources over time, and had recognised the importance of risk in the process. In developing theories of money, Keynes (1930, 1936), Hicks (1923, 1939), Kaldor (1939) and Marschak (1938) had conceived of “portfolio selection theory” in which uncertainty played an important role. However, for many economists during this early period, financial markets were still regarded as simple “casinos” rather than “markets” properly speaking. In their view, asset prices were determined largely by expectations and counter-expectations of capital gains. Keynes’s theory represents this attitude, which we will discuss his ideas of financial markets and banks later in this chapter.

However, a good attention was paid on the topic of speculative activity (i.e. the purchase/temporary sale of goods or assets for later resale). For instance, in the pioneering work on futures markets, Keynes (1930, 1936) and Hicks (1939) argued that the price of a futures contract for delivery of a commodity will be generally below the expected spot price of that commodity, what Keynes called “normal backwardation.” According to Keynes and Hicks, this was because hedgers shifted their price risk onto speculators in return for a risk premium. Kaldor (1939) went on to analyse the question of whether speculation was successful in stabilising prices and, in so doing, expanded Keynes's theory of “liquidity preference” considerably.

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