Money, Finance and Growth: A Critical Review - Moneta, finanza e credito: una rassegna critica

ECONOMIA INTERNAZIONALEINTERNATIONAL ECONOMICS

Volume LXVI, No. 4 November 2013

A. Al ShAyeb, A. hAtemi-J ‑ “An Empirical Investigation of the Potential Asymmetric Relationship between the Stock Market and the Exchange Rates in the UAE” ......................................... 425

b.m. FrAnciS ‑ “Causal Relationship between Financial Development and Economic Growth: A Case Study” ………………………… 439

m.n. JovAnovic, J. DAmnJAnovic ‑ “Geopolitics of the European Union: Are Steps backward the Way forward?” ............................ 455

o. ogun ‑ “Money, Finance and Growth: A Critical Review” ………………………… .......... 483

A.K. tiwAri ‑ “Decomposing Time‑Frequency Relationship between Interest Rates and Share Prices in India through Wavelets” .......................................... 515

K.P. uPADhyAyA, D. DhAKAl, S. thAPA ‑ “Remittances, FDI, and Economic Growth in South Asia: Evidence from Panel Data” ..... 533

CONTENTS

MONEY, FINANCE AND GROWTH: A CRITICAL REVIEW

1. introDuction

The relationship among monetary aggregates, financial innovation and economic growth remains on the front burner of contemporary research agenda in monetary economics and indeed, growth modeling. Little consensus seems to have been reached on the basis of empirical investigations as different perceptions hence, models of what constitute financial development, permeates the literature. A fly in the ointment here appears to be the continuing emergence and application of new econometric tools which have in some contexts resulted in relevant economic theories being relegated to the background, or, ignored altogether in some others.

Financial development which has been defined as the improvement in the capacity, quality and effectiveness of financial intermediary services (Calderon and Liu, 2003)1, was noted by Schumpeter many decades ago, as crucial to effective financial intermediation in the real economy, thereby stimulating investment and innovation. Empirical supports of various orientations exist for this view. For example, King and Levine (1993) show that the level of financial development is a determinant of future economic development and productivity, while Allen and Ndikumana (1998) argue on the basis of their empirical findings that, the effectiveness of economic policy is associated with how well financial markets work. However, the extent to which financial development supports growth in the economy will continue to be subject of controversy, at least in the theoretical and empirical literature.

This study presents a synthesis of the literature on financial development and growth emphasizing the subtle distinction between (the somewhat forgotten) monetary framework and the general financial sector framework with a neoclassical origin. It underscores the fact that the monetary models usually do not limit the channels

1 Cited in Kiran et al. (2009).

484 O. Ogun

of effect of policy actions, whereas the strictly financial sector models often lay claim to some detailed knowledge of the workings of financial factors vis‑à‑vis the economy. Thus, though they have the same goal, they nonetheless do diverge in terms of theoretical underpinning and variables of emphasis.

The rest of the paper is organized as follows. Section II is concerned with the theoretical literature while section III deals with the methodological literature. The succeeding section focuses on the empirical results while section V provides a concluding observation.

2. the theoreticAl literAture

In recent times, the theoretical background to the financial development and economic growth relationship has been embedded in the economics of information. It is assumed that there exists asymmetric information between the deficit (firms) and surplus units (households) which results in a higher cost to society. Hence, the need for financial intermediaries in the growth process, to provide access to various investments and achieve financial economies of scale. However, it is imperative to establish regulatory bodies to regulate financial intermediaries’ growth and operations as the financial sector expands.

Patrick (1966) appears to be the first to formally postulate a bi‑directional relationship between financial development and economic growth. He identifies two possible causal relationships between financial development and economic growth. The first is called ‘demand following’ and it views the demand for financial services as dependent upon the growth of real output and upon the commercialization and modernization of agriculture and other subsistence sectors. Thus, the creation of modern financial institutions, their financial assets and liabilities and related financial services are a response to the demand for these services by investors and savers in the real economy (Patrick, 1966). Based on this view, the more rapid the growth of real national income, the greater will be the demand by enterprises for external funds (that is, the saving of others) and therefore financial intermediation, since in most situations, firms will be constrained in financing expansion from internally generated depreciation allowance and retained profits. Therefore, real economic growth induces an expansion of the financial system although, finance is deemed passive in the growth process.

Money, finance and growth: a critical review 485

The second causal relationship between financial development and economic growth termed ‘supply leading’ states that ‘supply leading’ has two functions: to transfer resources from the traditional, low‑growth sectors to the modern high‑growth sectors and to promote and stimulate an entrepreneurial response in these modern sectors. This implies that the creation of financial institutions and their services occurs in advance of demand for them. Thus, the availability of financial services stimulates the demand for these services by the entrepreneurs in the modern, growth‑inducing sectors. In consonance with Gurley and Shaw (1960), Patrick (1966) concludes that financial institutions stimulate saving by offering a wide array of financial assets.

Levine (1997) represents an offshoot of Patrick’s paper, providing a survey of existing literature on finance and growth. Accordingly, it summarizes the views on the potential importance of finance in economic growth into three. The first views finance as enhancing efficient resource allocation and also a critical element in the growth process (Schumpeter, 1911; Goldsmith, 1969; McKinnon, 1973; Shaw, 1973; Odedokun, 1996; King and Levine, 1993). Secondly, finance is regarded as a relatively unimportant factor in growth (Robinson, 1952; Lucas, 1988). Finally, the third concentrates on the potential negative impact of finance on growth by considering the effects of financial liberalization on the real sector (vanWijnbergen, 1983; Buffie, 1984; De Gregorio and Guidotti,1995).

The emergence of the theories of endogenous economic growth as proposed by Romer (1990) and others introduced a new dimension to the relationship between growth and financial development. These models postulate that savings behavior directly influences not only equilibrium income levels but also growth rates (Greenwood and Jovanovic, 1990 and Bencivenga and Smith, 1991). Consequently, financial markets can have a strong impact on real economic activity. To this end, Hermes (1994) argues that financial liberalization theory and the new growth theories basically assume that financial development leads to economic growth. Murinde and Eng (1994), Luintel and Khan (1999) and Benhabib and Spiegel (2000) in support of the endogenous growth models, argue that there exists a two‑way positive relationship between financial development and economic growth.

By Allen and Ndikumana (1998), reasons in support of the growth and efficiency role of the financial system are essentially those of liquidity risk reduction and the facilitation of the management of risk by savers and investors. Furthermore, financial intermediaries evolve

486 O. Ogun

to channel saving into long‑term assets that are more productive than short‑term assets (Bencivenga and Smith, 1991). As the financial system develops, more choices are offered to investors, allowing them to allocate resources in more productive activities (Greenwood and Jovanovic, 1990).

In economies with unsophisticated financial systems, there are fewer investment opportunities, implying a higher probability that resources are wasted on unproductive uses. Another argument is centered on the role of the financial system in collecting and processing information about investment projects (Boyd and Prescott, 1986). Financial systems collect and evaluate information more effectively and less expensively than individual investors because of the economies of scale enjoyed by financial intermediaries. As a result, the overall cost of investment declines and this stimulates economic growth. A corollary of this argument is that low financial development increases the cost of investment and thus retards economic growth.

Aziz and Duenwald (2002) explain that financial development can affect growth through three channels:

i. It can increase the marginal productivity of capital.ii. It can raise the proportion of the savings channeled to investment

via financial development.iii. It can raise the private saving rate.

The positive correlation between growth and indicators of financial development was first documented by Goldsmith (1969), McKinnon (1973) and Shaw (1973). Empirical works that emerged since then find that cross‑country differences in financial development explain a significant portion of the cross‑country differences in average growth rates. According to Aziz and Duenwald (2002), recent studies on the relationship between finance and growth generally regress countries’ growth rates on an indicator of financial development and a set of control variables such as initial income, education, political stability and population growth. Subsequently, in line with King and Levine (1993) and Levine (1997), the following indicators of financial development were selected:

1. Liquid liabilities of the financial system to GDP which measures the size of financial intermediaries.

2. The ratio of bank credit to the sum of bank credit and central bank domestic assets.

3. The ratio of private credit to domestic credit.4. The ratio of private credit to GDP.


Benhabib and Spiegel (2000) using alternative specifications for growth accounting, adopt the standard Solow (1956) neoclassical growth model with human capital added as a factor of production. They first specify a growth and investment equation before specifying a financial development model. They adopt a neoclassical model for the growth equations in which the income of country i in period t, Y

it, will be a function of labor (L

it)

, physical capital (K

it) and human

capital (Hit). Using a Cobb‑Douglas technology model, where ε

t represents an i.i.d. disturbance term, and taking log differences, the specification in log difference is as follows:

Δyit = Δαit + αΔlit + βΔkit + γΔhit + eit (1)The above specification does not include initial income. This is

because initial income is a determinant of growth rates as well as an indicator of a country’s distance from its steady state. Hence, the greater the distance, the higher the predicted growth of per capita income through enhanced capital accumulation. Consequently, Benhabib and Spiegel (2000) argue in line with Levine and Zervos (1993) that, since the specification already incorporates capital‑accumulation rates while the production function is modeled directly, there is no additional role for initial income levels2. A second specification takes into cognizance an alternative model that allows for the possibility of technology diffusion across countries and provides a role for initial income. The intuition is that, the farther behind a country is in technology, the more it can learn from others.

Theoretical arguments have been advanced that market imperfections and borrowing constraints on investment rates can inhibit the accumulation of physical and human capital (Greenwood and Jovanovic, 1990; Bencivenga and Smith, 1991; Banerjee and Newman, 1991, and, King and Levine, 1993). Also, it has been argued that these effects are particularly strong in economies that are poor and have unequal income distributions (Galor and Zeira, 1993; Benabou, 1996; Ljungqvist, 1993). These studies suggest that financial backwardness may hinder the ability of agents to invest. This would be particularly true for, but not limited to, an agent’s own human capital, as liquidity constraints may preclude such an agent from investing in his own human capital at optimal levels. As a result, an interactive term with GDP per worker and financial‑development levels would be predicted to enter negatively as a determinant of the rates of physical and human‑capital accumulation.

2 Levine and Zervos (1993) suggest that financial development is an important determinant of economic growth.

488 O. Ogun

Similarly, the theory predicts that the role of financial development in factor accumulation would be particularly strong for economies with skewed income distributions. The more skewed the distribution of income, the larger would be the share of the population unable to acquire financing for profitable investments in either physical or their own human capital. This indicates the possibility of a relationship with income inequality and the degree of financial development. To test such hypotheses, they use the extent of the development of financial markets as a proxy for market imperfections and investigate their relationship with measures of wealth or income distribution to see if they influence either economic growth rates or rates of investment.

Alfaro et al. (2003) model an economy with a continuum of agents indexed by their level of ability to work for the foreign company or undertake entrepreneurial activities subject to a fixed cost. They argue that better and well developed financial markets enable agents take advantage of knowledge spillovers from FDI. Following Levine (1993), Alfaro et al. (2003) include four variables in their work. The first is liquid liabilities of the financial system measured by currency plus demand and interest bearing liabilities of banks and nonfinancial intermediaries divided by GDP. This is the broadest measure of financial intermediation and includes three types of institutions namely the central bank, deposit money banks and other financial institutions.

The second is the commercial – central bank assets which equal the ratio of commercial assets divided by the sum of commercial banks’ assets and central bank assets. This measure reflects the extent to which commercial banks and the central bank allocate society’s savings. These measures do not differentiate between the end users of the claims of financial intermediaries. The third is the bank credit which equals the credits by deposit money banks to the private sector. The theoretical model explained by Alfaro et al. (2003) shows that improvements in financial markets increase output by increasing the marginal product of foreign direct investment (FDI).

The financial repression thesis of McKinnon (1973) and Shaw (1973) contends that financial liberalization in the form of an appropriate rate of return on real cash balances is a vehicle for promoting economic growth. The essential thrust of this theory is that a low or negative real interest rate will discourage saving. This will reduce the availability of loanable funds for investment which in turn, will lower the rate of economic growth. Thus, the McKinnon‑Shaw model posits that a more liberalized financial system eliminating interest rate ceilings and direct credit programs


will induce an increase in saving and investment and therefore, promote economic growth. In addition, it will enhance innovation and induce greater operational capability in financial institutions thereby, supporting economic growth.

Studies on information asymmetry management have also been influential in the debate on the influence of financial factors in the growth process. Usually, the argument is that techniques helping to reduce asymmetric information and thus stemming the occurrence of adverse selection and moral hazards increase efficiency hence, growth. Two broad categories of such studies can be identified. First, those focusing on micro arrangements involving lending relationships between banks and customers as inspired by Akerlof (1970) (see e.g. Brennan and Kraus, 1987; Nachman and Noe, 1994; DeMarzo and Duffie, 1999; Fishman and Parker, 2010). Second, those studies analyzing the implications of government interventions in financial markets following crisis (see e.g. Aghion et al., 1999; Gurton and Huang, 2004; Trew, 2006; Philippon and Schnabl, 2009; Maskin and Tirole, 1992; Golosor and Tysvinski, 2007; Minelli and Modica, 2009; Ennis and Keister, 2009; Tirole, 2012; Farhi and Tirole, 2012). However, it appears that the overriding aim of such innovations/policy interventions in tackling the problem of asymmetric information at both the industry and government levels is to restore equilibrium (or eliminate distortions) and thus, the related financial efficiency may only protect projected profit level, leveling off in its effect thereafter.

Generally, since around the early 1960s, studies on the importance of financial factors (that is, financial deepening or liberalization) in the growth process appear to have followed two directions. The first is embedded in strictly monetary context and thus lay emphasis on the growth of real balances as the critical input in the growth process, as well as an intermediation effect in the ratio of monetary aggregates to income (e.g. Wallich, 1969; Stein, 1970; Sinai and Stoke, 1972; Jao, 1976). The money in the real balances and the intermediation variable typically ranges from M1 to M3. As no rate of return and supply of saving for investment are usually independently included in this line of studies, it is clear that their emphasis is on money as a factor of production. In this regard, the inclusion of narrow money in the definition of monetary aggregates employed appears to have been influenced more by monetization of, rather than the strict supply of factor inputs to, the economy. Hence, successful monetization process would under these models equate with a growing distance from the barter economy. In this sense, the models mostly capture the reaction function of the central bank.

490 O. Ogun

Furthermore, this approach presupposes that growth of real balances could set off a chain of reactions geared towards enhancing the growth of aggregate demand. In this context, any combination of wealth effect, liquidity effect, cash flow effect, balance sheet effect, real interest rate effect and exchange rate effect could be operational at the same time. In essence, growth could be stimulated via consumption (including, consumer spending), investment (direct or portfolio) or international trade. However, an ex post prediction of which effect would be triggered may be inaccurate and unreliable. Hence, Monetarists would submit that, knowledge about the way the economy works is limited.

Further justification for the approach may be found in the developing economies where the rate of cash holdings and transactions is usually very high; some of the outcomes of such transactions do find their way into the banking system and most enter the national income through taxation3. In all, the empirical support for the potency of real balances under this approach is very robust. However, only very little support has been generally recorded for the intermediation effect.

In terms of effectiveness horizon, the studies in this line of investigation follow the Monetarists tradition of attributing only short‑run effect to monetary factors. Historically, Levhari and Patinkin (1968) and Johnson (1969) appear to be the first accurate theoretical analyses of the growth effect of transiting from barter to monetary economy4. The Levhari and Patinkin study was a reaction to the odd result obtained by Tobin (1965) from a substitutability framework that monetary expansion and deflation negatively affect growth through a depressive effect on saving hence, capital accumulation. Subsequently, the study demonstrated two scenarios under which money would contribute positively to the growth process. First, the

3 It has to be acknowledged however that, a cash transaction (outside money) dominated economy may not grow as fast as an inside money dominated type. In addition, the high currency holdings in these economies facilitate criminal activities producing an unusually large second or underground economy which tends to reduce the recorded size of the official or main economy.

4 There have been quite a number of criticism of the studies by Levhari and Patinkin (1968) and Johnson (1969) (see e.g. Marty, 1969; Hahn, 1969; Stein, 1970), but, the criticisms do not appear to have vitiated the essential message hence, the conclusions of the studies regarding the importance of money in the growth process.


authors adopted a complementarity hypothesis to show that when the consumption services from monetary expansion are accounted for through value imputation, money actually raises the growth rate of the economy. Second, money as a producer good was shown to contribute directly to the growth process through its output increasing effect5. As events were to unfold, money as an input in the production function became the more fashionable approach to analyzing its influence on economic activities6.

The Johnson’s study was particularly targeted at showing sequentially, the growth benefits of the different means of exchange ever used in the world. He defined growth variously to mean, a nominal output measure (that is, nominal return times the material wealth used in production, with money replacing the material wealth, fully or partially, when monetization commences), the opportunity cost return in terms of benefits (utility) from the use of money instead of goods/services in transaction (that is, revealed preference) and a welfare definition in terms of consumers’ surplus. With these, he illustrated vividly that real income increases as the economy progresses from barter transaction through trading places, commodity money and standard to fiat money7.

It is clear from the Johnson’s study that the emergence of money in the fiat form is an act of innovation. Undoubtedly, his conclusions drive home the point that consumers’ surplus which is a key component of real income is strictly a derivative of technological innovation8. It follows therefore that the insistence of the Monetarists

5 These conclusions remain the same even when the assumption of an outside money system is replaced by that of inside money as long as money enjoys the payment of interest which would, under a liberalized economic system, serve to match price level changes thereby leaving steady state growth unaffected by inflation. Note also that, as shown in the study, under the scenario of money being a producer good, no value imputation into the production services of money is necessary in order to avoid double counting the contribution of money.

6 Some of these studies were cited earlier under the strictly monetary framework.

7 This is irrespective of whether or not the fiat money (as in bank deposit) enjoys pecuniary interest payment.

8 Technological innovation in this sense consists of two components viz: financial sector related innovation including the invention of money, which is generally static and thus generating a level effect on consumers’ surplus hence, real income, and, innovation related to production processes which is inherently dynamic and thus, qualifies as a long-run growth driver

492 O. Ogun

on short‑run real growth effect of monetary factors appears to be strongly indicative that, not all innovative processes translate to long‑run effect9.

The second direction which has been dictated by the theoretical insights of the Mckinnon‑Shaw theses is basically neoclassical in orientation10. The basic approach is either, to assume complementarity between money and physical capital such that the accumulation of money balances is targeted at a lump‑sum capital; rather than money, the savings ratio or the investment ratio is emphasized; or, to adopt an expanded intermediation view (based on the debt‑intermediation concept) generating higher saving and/or investment ratio. In both cases, real rate of return either on deposit or in general is explicitly incorporated into the models. Unlike the strictly monetary approach, the emphasis under this framework is on the explicit innovative processes in the financial sector as they translate to larger investible resources and higher growth.

A further development of this approach as reflected in the explorative studies of the Mckinnon‑Shaw school, is to identify other sources of financial repression hence, potential sources of growth (besides real bank finance and ceiling on financial prices in the face of high and unsteady inflation) such as high reserve requirement and liquidity ratios and, restrictions on market entry and scope of investment. Key members of this school include Kapur (1976), Galbis (1977), Mathieson (1980) and Fry (1978, 1980a, 1980b)11.

Typical of the innovative activities of banks which often translate to relatively higher real return to savers and simultaneously, lower costs to investors are: accommodation of liquidity preferences, reducing risk through diversification, reaping economies of scale in lending, increasing operation efficiency and reduced information costs to both savers and investors via specialization and division of

– including consumers’ surplus. Also, it has to be acknowledged that the emergence of technological progress or innovation as a key long‑run growth driver is traceable to neoclassical economists – Solow (1956) and Swan (1956).

9 See also Thirlwall (1974) – discussed briefly under methodological literature – for another earlier restatement and illustration of the Monetarists’ position.

10 Both economists, Ronald Mckinnon and Edward Shaw are neoclassical in orientation.

11 It should be noted that both the monetary and the financial sector frameworks stress the need to keep inflation in check for expected outcome to materialize.


labor12. Such innovative activities of banks underscored by the basic Mckinnon‑Shaw doctrine of financial repression and its converse, financial liberalization, were noted earlier in the paper, to have received attention under the endogenous growth theory. In such augmented growth models, financial factors (variously represented or modeled) enter explicitly as factor input.

Studies following in the Mckinnon‑Shaw tradition have tended to suggest that financial factors exert long‑run real growth effect. Such belief, which obviously derives from the innovative activities of financial institutions appears to be so strong as to warrant some of the studies averring that, financial factors especially real interest rate, constitute the only long‑run variables in the typical growth model (see e.g. Mathieson, 1980; Fry, 1980b). Additional factors emphasized as sources of non‑neutrality include the required reserve ratio and credit rationing by banks (Kapur, 1976)13. However, the submission of the Monetarists stated earlier on the long‑run status of financial innovations appears instructive.

3. the methoDologicAl literAture

According to Güryay et al. (2007), two trends in the methodological literature can be discerned. The first involves testing the hypothesis of whether a relationship exists between economic growth and financial development. It adopts a single measure of financial development and tests the hypothesis on a number of countries using either cross section or panel data techniques (Jung, 1986; Roubini and Sala‑i‑Martin, 1992; Demetriades and Hussein, 1996 and Luintel and Khan, 1999). The second trend examines the hypothesis for a particular country using time series techniques. Some papers written in this respect for particular countries include, Odedokun (1989) for Nigeria, Wood (1993) for Barbados, Murinde and Eng (1994) for Singapore, Lyons and Murinde (1994) for Ghana, Aziz and Duenwald (2002) for China, Güryay et al. (2007) for Cyprus, Athanasios and Adamopoulos (2009) for Greece.

12 For source and further details, see Fry (1978). See also Levine (2004) for a different classification and description of the innovative activities of the financial sector.

13 Credit rationing in the Kapur’s study implies that, banks finance only a fraction of firms’ replacement capital.

494 O. Ogun

Various estimation techniques have been used to test the relationship between financial growth and economic growth. Güryay et al. (2007) investigate this relationship using the Ordinary Least Squares Estimation (OLS) Method and the Granger Causality test. In line with Durlauf and Quah (1998) and Temple (1999), Allen and Ndikumana (1998) highlight the importance of using panel data analysis in examining cross‑country growth dynamics by comparing the results obtained using three different techniques. They include simple OLS regressions which incorporate a common intercept for all countries, regressions which include country‑specific fixed effects, and regressions including a high‑income dummy.

Benhabib and Spiegel (2000) attempt to diminish the problems of simultaneity bias caused by physical and human capital accumulation, by using lagged values of the dependent variables as instruments for all of the independent variables in their growth regressions. They therefore, use the Generalized Method of Moments (GMM) application because it does not rely on the presence of random individual effects and secondly to account for endogeneity of physical capital accumulation. Benhabib and Spiegel (2000) distinguish their work from King and Levine (1993) in the use of panel data to examine the robustness of indicators of financial development to the inclusion of country‑specific fixed effects.

In their study, King and Levine demonstrate that the financial‑sector reforms in five developing countries were closely associated with increases in their measures of financial development. Furthermore, the introduction of country‑specific fixed effects emphasizes the within‑country information available in the data. Three important facts stand out from the results. First, it is clear that there is a large amount of within‑country variation in the financial indicator data over the course of the sample which indicates that a panel sample of financial indicators in particular will provide significant additional information relative to a cross‑section. Second, the series are not generally monotonic as countries used in the analysis experienced periods of financial deepening, as well as declines. Third, there is a large amount of within‑country variability in the financial‑indicator data that is not obviously associated with large financial‑sector reforms.

Muhsin and Pentecost (2000) empirically test the causality between financial growth and economic growth by applying the Granger causality test following Granger (1969) and the cointegration technique pioneered by Engle and Granger (1987). According to this technique, Engle and Granger (1987) demonstrate that once


a number of variables are found to be cointegrated, there always exists a corresponding error‑correction representation which implies that changes in the dependent variable are a function of the error‑correction term as well as changes in other explanatory variables.

Apart from GMM, three other system approaches are popular in money, finance and growth analyses; they are vector autoregressive methods (VAR), structural vector autoregression models (SVAR), vector error correction technique (VEC) and dynamic stochastic general equilibrium models (DSGE). While the basic VAR and DSGE are generally focused on the short‑run, both SVAR and VEC enable investigation of the long‑run relationships (under different conditions) among the variables included in the models. Different varieties of these models are in use and have been widely applied to studying macroeconomic responses to innovations and most recently the effects of quantitative easing and unconventional monetary policy in the advanced economies (see e.g. Bridge and Thomas, 2012; Chen et al., 2012; Joyce et al., 2012).

In general, it appears that the emerging models of financial development and its growth effect as well as the methodology warranted have largely been influenced by the perception of the different writers on the theoretical role of money and finance in the economy as well as the emergence of new analytical techniques. The following two major arguments have been advanced by those adducing long‑run growth effects to finance/financial development. One, that expanded financial intermediation represented/epitomized by increasing real rate of return (or real interest rate) encourages innovation and thus, is key to the improvement of investment quality hence, productivity growth, which is a long‑run growth driver. Two, that money and finance is needed to continuously lubricate the engine of growth – this would appear to effectively tackle the demand following argument of Robinson (1952), Lewis (1955) and Kuznets (1955).

At the opposite pole are two equally compelling and perhaps more powerful theoretical arguments. One, it appears that if the notion of long‑run is properly understood, the key ingredient or fall out of financial development that is, real interest rate, does not exist in the long‑run (see Ogun, 2014). In effect, financial innovation only supplies short‑run determinants of productivity growth. Two and in defense of Robinson, Lewis and Kuznets, the essence of introducing money into the production process is to eliminate the use of goods/services in transaction; the more money added, the more resources are freed for production. In the long‑run, no more

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resources would be freed from the addition of more money14. This appears to dovetail with the strictly monetary framework discussed earlier under approaches of financial deepening. It is a scenario that appears to depict the standard case of the typical advanced capitalist economy analyzed by the aforementioned authors and it is consistent with Friedman’s (1968) view of the unparalleled role of money in economic activity in the short‑run15.

It is clear from the foregoing therefore that the situation in which money or finance plays very important role in real sector growth is the less developed economies (usually operating at less than full employment equilibrium). Such economies are characterized by less sophisticated financial system that is more often than not, marked by little innovation and very large informal sector where barter and trading places flourish. Nonetheless, the financial growth models of such economies may still be restricted to the short‑run which in this case, is lengthened16. By these submissions, it appears clear that any econometric model of the role of money in the growth process should follow strongly in the steps of the relevant economic theory.

4. the emPiricAl literAture

Güryay et al. (2007) empirically examine the relationship between financial development and economic growth in Northern Cyprus. They adopt a modified growth model of Odedokun (1989) as used

14 See Thirlwall (1974) for an earlier articulation of this view which is however consistent with the traditional Monetarists belief on the growth effect of monetary factors. The view is also consistent with the observation in Benhabib and Spiegel (2000) that the traditional approach to modeling the role of financial development in the growth process is in terms of its influence on the accumulation rate of a nation’s factor stocks or primitives, particularly, of physical and human capital. It is not very clear that, there are convincing arguments in the literature to warrant an abandonment of the traditional approach.

15 The growth leading hypothesis usually associated with Friedman and Schwartz (1963) relates only to the short‑run (business cycles) and may not be construed as applicable in all situations.

16 In addition to the two arguments against the recent emergence of long‑run models of financial sector’s contribution to the growth process, there should be a realization of the fact that the journey from barter trade to fiat money spanned several centuries and the card and other electronic payment technologies currently in use date back many decades.


by Ram (1999) for the case of Cyprus. The estimated equation is written as follows;

GY = β0 + β

1(GL)+ β

2(GX)+ β

3(IY)+ β

4(DEP)+ β

5(LOA) (2)

Where,GY = annual growth rates of real GDPGL = annual population growthGX = annual growth of exportIY = the ratio of domestic investments to GDPDEP = the ratio of deposits to GDPLOA = the ratio of loan to GDP

Using a multivariate vector‑autoregressive approach, Xu (2000) finds a negligible positive relationship beween financial development and economic growth in 41 countries between 1960 and 1993. However, it has been observed that inability to confirm the existence of causality running from financial intermediary development to economic growth is due to independent factors (Neusser and Kugler, 1996; Berthelemy and Varoudakis, 1998; Ram, 1999). Allen and Ndikumana (1998) use various indicators of financial development in their investigation of the growth stimulating role of financial intermediation within the Southern African Development Community (SADC). The results lend some support to the hypothesis that financial development is positively correlated with the growth rate of real per capita GDP.

The relationship captured in the Allen and Ndikumana study is more evident in regressions using pooled data (5‑year cross sections) than those using annual data. The econometric analysis is based on a reduced‑form equation relating the growth rate of real per capita GDP to an indicator of financial development, controlling for other factors that affect economic growth. The study draws heavily from Levine (1997) in motivating the link between financial development and economic growth. Unlike the standard empirical studies in economic growth (see, for example Mankiw et al., 1992), the empirical model used in this paper is not explicitly derived from a production function. Following the practice in recent studies, the analysis uses a panel data approach to take into account the unobservable country‑specific effects (see Darlauf and Quah, 1998). The approach also offers greater flexibility in the specification of the growth equation than single cross‑country regressions and thus can potentially reduce chances of mis‑specification. The model is of the form: lnyit – lnyi,t–τ = αi + βlnyi,t–τ + γ lnFINi,t–τ + δ lnXi,t–τ + uit (3)

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where y is real per capita GDP for country i at time t, T equals 1 for annual data and 5 for pooled data, αi is the country‑specific intercept, FIN is an indicator of financial development, X is a vector of control variables, and u is an error term assumed to be white noise. The variables FIN and the control factors are appropriately lagged to avoid possible simultaneity bias.

The indicators of financial development used in the regressions are (as percent of GDP), credit to the private sector, the volume of credit provided by banks, and liquid liabilities of the financial system (measured by M3), and an index of financial development combining these three indicators. The composite index of financial development (FINDEX) is calculated using a formula that is similar to the algorithm developed by Demirgüç‑Kunt and Levine (1996). For a country i in year t,

21

', , , ,it i t T i i t T i t i t itlny lny lny lnFIN lnX u (3)

where y is real per capita GDP for country i at time t , T equals 1 for annual data and 5 for

pooled data, αi is the country-specific intercept, FIN is an indicator of financial development, X

is a vector of control variables, and u is an error term assumed to be white noise. The variables

FIN and the control factors are appropriately lagged to avoid possible simultaneity bias.

The indicators of financial development used in the regressions are (as percent of GDP), credit to

the private sector, the volume of credit provided by banks, and liquid liabilities of the financial

system (measured by M3), and an index of financial development combining these three

indicators. The composite index of financial development (FINDEX) is calculated using a

formula that is similar to the algorithm developed by Demirgüç-Kunt and Levine (1996). For a

country i in year t,

,

1

1 100*m

j itit

j

FFINDEX

m Fj (4)

Where F is an indicator of financial development, Fj is the sample mean of the indicator F, and

m is the number of indicators included in the computation of the index (m = 3 in this case). All

these financial indicators are positively correlated with growth, indicating a potential positive

effect of financial intermediation on growth. The following control variables are included in the

regressions: inflation, measured as the annual percentage change in the GDP deflator lagged one

year, government consumption, measured as the lag of general government consumption as a

(4)

where F is an indicator of financial development, Fj is the sample mean of the indicator F, and m is the number of indicators included in the computation of the index (m = 3 in this case). All these financial indicators are positively correlated with growth, indicating a potential positive effect of financial intermediation on growth. The following control variables are included in the regressions: inflation, measured as the annual percentage change in the GDP deflator lagged one year, government consumption, measured as the lag of general government consumption as a percent of GDP, openness, measured as the lag of the sum of imports and exports as a percent of GDP, debt service is the lag of the ratio of debt service to GNP. The regression results reveal a positive and significant relationship between economic growth and the size of the financial sector as measured by liquid liabilities of financial institutions (M3 as a percentage of GDP).

Aziz and Duenwald (2002) study the relationship between economic growth and financial development in China in the post‑1978 reform period. Rather than use a cross country analysis, they make use of the provincial‑level data. Provinces are grouped according to certain economic characteristics using dummies. Three groupings are used with the financial intermediaries categorized into: those with above average and below average levels of growth, those with above average levels and below average levels of financial intermediation and those with above average and below average levels of State Owned Enterprises (SOE) concentration. The advantages identified with the


data used is that differences in the level of economic and financial development among the provinces contain information that can be exploited: China’s large population and limited labor and capital mobility between provinces make the study analogous to a cross country study of medium sized countries; it increases the likelihood of homogenous data compilation methodologies and expands the sample size considerably.

As regards the paucity of financial data such as private credit, the share of credit predicted by share of SOE value added in GDP is used as proxy. Secondly, fixed effects panel regression of the total bank lending to GDP ratio on the share of SOE in industrial output is estimated. Loans to the non‑state sector are proxy by discounting from the total bank lending, the proportion explained by the share of SOE in industrial output ratio in the estimated equation. The methodology adopted includes a series of fixed effects panel regressions estimated with various combinations of control variables to draw inferences about the role played by bank intermediation in growth, resource mobilization and productivity. The equation estimated is as follows

yit = αi + βXit + γFit + δKit + εt (5)where y is the dependent variable proxy by growth, investment and productivity; X is the set of factors that include lagged per capita real GDP, population growth and investment; F is the financial intermediation variable as measured by total bank loans – bank loans to SOEs and bank loans to non‑state sector; K is a set of control variables such as fiscal surplus, share of SOEs in industrial output, dummy for coastal region and FDI; i indicates a province while t refers to time period

They find a positive correlation between growth and financial intermediaries, although the non‑state sector which was fastest growing was not financed by the domestic financial intermediary. The financial system development as measured by bank loan‑to‑GDP ratio and provinces with higher concentrations of state‑owned enterprises had higher loan‑to‑GDP ratio. Panel regressions suggest that after conditioning on a number of variables including initial per capita, GDP, population growth, investment, FDI, concentration of SOEs, fiscal revenues to expenditure – the level of financial development is not a statistically significant explanatory variable for observed differences in per capita GDP growth rate.

Benhabib and Spiegel (2000) obtain results that show that indicators of financial development are correlated with both total

500 O. Ogun

factor productivity growth and investment. The indicators of financial development were obtained from King and Levine (1993). The first variable is DEPTH, a proxy for the overall size of the formal financial intermediary sector, measured as the ratio of liquid liabilities of the financial sector to GDP. The second indicator is BANK, the ratio of deposit‑money bank domestic assets to the sum of deposit‑money bank assets and central‑bank’s domestic assets.

King and Levine (1993) introduce the second indicator noted in the preceding paragraph in order to emphasize the risk‑sharing and information services stressed in their theory that banks are most likely to provide. The third variable is PRIV/Y, the ratio of claims on the nonfinancial private sector to GDP, which indicates the share of credit funneled through the private sector. They also look at two interactive terms related to financial development that is, income‑distribution data which was obtained from the Deininger and Squire (1996) data set and a measure of income distribution, the Gini coefficient, because it is available for a larger set of countries. This variable is interacted with the financial‑depth indicator to produce a variable called DEPTHGINI. Finally, initial income interacted with financial depth is called DEPTHGDP.

Financial development is likely to be endogenous with respect to current‑income levels and investment rates (Greenwood and Jovanovic, 1990). To address these endogeneity issues, they use beginning‑of‑period values of the indicators of financial development. Nevertheless, it is noted that the extent to which financial markets may develop in anticipation of future investment and growth brings up the issue of simultaneity in the analysis. However, the indicators of financial development that correlate with factor productivity growth differ from those that encourage investment. In addition, many of the results are sensitive to the inclusion of country fixed effects, which may indicate that the financial‑development indicators are used as proxy for broader country characteristics. Furthermore, their results suggest that financial development positively influences both rates of investment and total factor productivity growth. However, different indicators of financial development appear to be important for different components of growth.

In the case of total factor productivity growth, the liquidity indicator and the ratio of financial assets of the private sector to GDP were both found to positively affect growth after accounting for rates of factor accumulation. However, only the ratio of financial assets of the private sector to GDP variable was robust to the inclusion of country fixed effects. In the case of the impact of


financial development on physical‑capital accumulation rates, all of the indicators entered significantly with their predicted impacts with fixed effects excluded, confirming results in the earlier literature. When fixed effects were introduced, only the ratio of banking to total assets variables and the interactive initial income and income inequality variables entered significantly with their predicted signs. These variables failed to enter expectedly into the growth equations after accounting for factor accumulation rates. In the case of human‑capital accumulation, the ratio of banking to total assets was the only indicator that entered with its predicted sign with and without accounting for country‑specific fixed effects. However, they did find that ratio of liquid liabilities to income entered expectedly after fixed effects were included.

An interesting disparity arose concerning the variable interacting income inequality with financial development. The variable has its predicted positive impact on physical‑capital accumulation but entered insignificantly in the determination of human‑capital accumulation rates. This disparity is surprising because many of the theoretical arguments that opened a channel for a positive role for income inequality in growth stressed its impact on human, rather than physical, capital accumulation (Saint‑Paul and Verdier, 1993).

Muhsin and Pentecost (2000) examines the causal relationship between financial development and economic growth in Turkey using Granger causality tests, cointegration and vector error correction methodology (VECM). The conclusion is that, works that used a single measurement of financial development may possibly be subject to a measurement bias because their results show that different measures of financial development do give rise to different causal patterns between financial development and economic growth. The empirical results showed that the direction of causality between financial development and economic growth in Turkey is sensitive to the choice of proxy used for financial development. For instance, when financial development is measured by the money‑income ratio, the direction of causality runs from financial development to economic growth, but when the bank deposits, private credit and domestic credit ratios are alternatively used to proxy financial development, growth is found to lead financial development.

Muhsin and Pentecost (2000) describe five proxies of financial development which they develop to test the robustness of previous works. They include the ratio of money to income, the ratio of banking deposit liabilities to income, the ratio of private sector credit to income, the share of private sector credit in domestic credit and

502 O. Ogun

the ratio of domestic credit to income. These proxies are considered in turn. Monetary aggregates provide a set of variables which may be used to measure the extent of financial development (De Gregorio and Guidotti, 1995 and Lynch, 1996). In the literature, the most commonly used measure of financial development is a ratio of some broad measure of the money stock, usually M2, to the level of nominal income (King and Levine, 1993; Wood, 1993; Murinde and Eng, 1994; Lyons and Murinde, 1994; Berthelemy and Varoudakis, 1995; Arestis and Demetriades, 1997). This simple indicator measures the degree of monetization in the economy.

The monetization variable is designed to show the real size of the financial sector of a growing economy in which money provides valuable payment and saving services. The ‘narrow money’ stock best reflects payment services while ‘broad money’ the savings function. Narrow money balances rise in line with economic transactions, but broad money rises at a faster pace if financial deepening is occurring (Lynch, 1996). In some cases, monetary aggregates may be very poor indicators of the extent of financial development.

De Gregorio and Guidotti (1995) criticize the use of narrow money to income ratio as a proxy for financial development on the grounds that a high level of monetization (M1/GDP) is most likely the result of financial underdevelopment, while a low level of monetization is the result of a high degree of sophistication in financial markets which allows individuals to economize on their money holdings. De Gregorio and Guidotti (1995) suggest the use of a less liquid monetary aggregate (M3 or M2/GDP) as a proxy for financial development. An alternative to the broad money ratio is ratio of bank deposit liabilities to income as a quality proxy for financial development (Demetriades and Hussein, 1996; Luintel and Khan, 1999).

In developing countries, a large component of the broad money stock is held outside the banking system. In principle, a rising ratio of broad money to income may reflect the more extensive use of currency rather than an increase in the volume of bank deposits. Some writers therefore opine that in order to obtain a more representative measure of financial development, currency in circulation should be excluded from the broad money stock. One such proxy is the ratio of bank deposit liabilities to income (BDY). The ratio of domestic credit to income (DCY) can be used as another proxy for financial development (Odedokun, 1989). This represents the domestic assets of the financial sector. This is the major item on the asset side of the consolidated balance sheet of the financial sector. It is expected


to increase in response to improved price signaling, represented primarily by the establishment of positive real interest rates.

In order to obtain a more direct measure of financial intermediation, the private sector credit ratio (CPY) is also employed as a fourth measure of financial development. It is assumed that credit provided to the private sector generates increases in investment and productivity to a much larger extent than do credits to the public sector. It is also argued that loans to the private sector are given more stringently and that the improved quality of investment emanating from financial intermediaries’ evaluation of project viability is more significant for private sector credits.

Another proxy for financial development is the share of the private sector credit in the domestic credit. This indicator captures the aspect of domestic asset distribution of an economy. It is believed that a financial system that simply funnels credit to the government or state‑owned enterprises may not be evaluating managers, selecting investment projects, pooling risk and providing financial services to the same degree as a financial system that allocates credit to the private sector. Lynch (1996) argues that government credit from banks in countries with a highly regulated financial system is frequently captive and that banks have no control over its use. Consequently, the important credit allocation role of banks is best represented by their lending to the private sector. The share of the credit given to the private sector in the domestic credit may reflect another aspect of the financial sector and can be used as a proxy for financial development.

Muhsin and Pentecost (2000) examine the direction of causality in the long‑run relationship between each of the proxies for financial development (FD) and income using the Johansen cointegration procedure (Johansen, 1988; Johansen and Juselius, 1990). The proxies for financial development are the ratio of broad money to gross national product (m2y), the ratio of bank deposit liabilities to GNP (bdy), the ratio of claims on the private sector to GNP (cpy), the share of private sector credits in the domestic credit (cpd), and the ratio of domestic credit to GNP (dcy). Economic growth is proxy by the change in per capita GNP (yp). All the variables are in logarithmic form and enter the cointegration analysis in levels. It should be noted that the correlation between financial development and economic growth is found to be positive in all cointegrated relationships in the bivariate context. The statistical tests reveals that all causal relationships between finance and growth are not in the nature of supply leading or demand following, rather it depends upon the measures of financial development.

504 O. Ogun

Alfaro et al. (2003) investigate the role that financial markets play in the relationship between foreign direct investment (FDI) and economic development. The control variables are black market premium, institutional quality captured by the ICRG measure called the ‘risk of expropriation’, rate of inflation and trade volume17. Furthermore, FDI multiplied by financial markets enters as an explanatory variable leading to the following regression equation:

GROWTHt = β0' + β

1'FDI + β

2' (FDIt * FINANCEt) + β

3' FINANCEt +

+ β4' CONTROLSt + vt (6)

The variables were partitioned into stock market and financial market related. The results indicate that well developed financial markets are synonymous with gains from FDI while FDI plays an ambiguous role in contributing to development. Athanasios and Adamopoulos (2009) investigate the causal relationship between financial development and economic growth for Greece for the period 1978‑2007 using a Vector Error Correction Model (VECM). Questions are raised as to whether financial development causes economic growth or otherwise taking into account the positive effects of industrial production index. Financial market development is estimated by the effect of credit market development and stock market development on economic growth. The equation estimated is as follows

GDP = f(SM, BC, IND) (7)where:GDP = the gross domestic productSM = the general stock market indexBC = the domestic bank credits to private sectorIND = the industrial production index

The results of Granger causality tests indicate that causality runs from economic growth to stock market development and industrial production index, with the latter causing credit market development. Therefore, it can be inferred that economic growth has a positive effect on stock market development and credit market development through industrial production growth in Greece. Kiran et al. (2009) analyze the relationship between financial development and economic growth for ten emerging countries over the period 1968‑2007 by using panel unit root tests, panel cointegration and Fully Modified

17 ICRG is International Country Risk Guide.


OLS (FMOLS) methods. They employ three measures of financial development to capture variously the channels through which financial development can affect economic growth. In their empirical analysis, they investigate the long‑run relationship between financial development and economic growth in ten emerging countries namely Egypt, India, Israel, Malaysia, Mexico, Pakistan, Peru, Philippines, Thailand, Tunisia.

The variables considered include, GDP per capita, a measure for financial development and a set of control variables that includes commonly used variables in the literature such as gross fixed capital (C), general government final consumption expenditure as share of GDP (G), and volume of trade as share of GDP (T). The channels identified include:

(i) The liquid liabilities of the financial system (LL), which is the broadest measure of financial development defined as currency plus demand and interest bearing liabilities of bank and nonbank financial intermediaries divided by GDP (M3/GDP).

(ii) Bank Credit (BC) is defined as credit by deposit money banks to the private sector divided by GDP.

(iii) Private sector credit (PC) equals the value of credits by deposit money banks and other financial institutions to private sector divided by GDP.

Furthermore, the model generates consistent estimates by employing the Pedroni FMOLS procedure and the findings show that financial development has a positive and significant effect on economic growth for all different financial indicators.

Nor and Ergun (2009) explore the role of economic development in financial linkages between countries. Cointegration techniques with rolling‑window approach and Vector Error Correction Model (VECM) are employed. The empirical data analyzed consists of stock market indices and exchange rates for one least developed country, developing countries and developed countries and spans the period from 1997 to 2007. The findings are in four parts: the US has a distinct dominant role over the countries; Japan has a limited role in terms of stock market linkages; the Euro take the dominant role from the US in exchange rate linkages, and, exchange rate linkages are much stronger compared to stock market linkages in all sampled countries. Overall, economic development stimulates financial linkages.

A major limitation of using M2 for market developing countries is predicated upon the fact that it is an inefficient measure of the financial market, since it consists mainly of currency and the stock

506 O. Ogun

market is not fully developed, making it difficult to apply models that have been applied elsewhere18. The incidence of capital flight also makes it difficult for the financial sector to develop to its full potential in developing countries.

In general, most studies in the strictly monetary framework, referenced under the theoretical literature, tend to suggest empirically the dominating influence of the growth of real balances in the growth process but have been characterized by rather less encouraging performance of the intermediation effect19. For contrast, studies adopting the strictly financial sector framework, as identified under the theoretical literature, have recorded rather very impressive result on the intermediation effect. In these latter studies, the intermediation effect is mostly proxy by the saving or investment ratio as against the money‑income ratio of the monetary models.

5. concluDing obServAtionS

Overtime, different definitions/concepts of financial development have been propounded and tested for growth effects in the literature. And mostly, such definitions/concepts correspond to different schools of thought active in this area of economics. In recent times, the neoclassical view/concept currently in the garb of endogenous growth model has become relatively more popular. This concept which is all‑encompassing has tended to spell out in some details the instruments and channels of effect of financial sector development. And, because it stresses the innovative activities of the financial sector, it tends to advance the view that financial factors generate long‑run effects on output growth. Some emerging methodologies and resultant empirical evidences have given fillip to this position. Accordingly, this view and related approach have dominated current thinking in the literature about the way money and finance affects the economy.

Somewhat forgotten is the strictly monetary framework that hardly dwells on the channels or mechanisms of effect of monetary factors on economic activities. It is usually constructed on the

18 See the section on the theoretical literature for the justification of currency admitting measures under the monetary framework.

19 Perhaps, Wallich (1969) is the only study in this category reporting a consistently positive association between the degree of financial intermediation and growth.


implicit assumption of limited knowledge about the channels through which policy initiatives would affect the economy. Thus, it does not limit the ways in which monetary factors interact with real variables to generate growth in the economy. It is also usually accompanied by the belief that monetary factors only generate short‑run effects on economic activities. Thus, studies employing this framework are usually modeled in terms of the short‑run.

Given this dichotomy in the theoretical and empirical literature, should we on the basis of the dominance of the neoclassical view and approach, adopt it and abandon completely the monetary framework? An answer to this poser may not materialize until more painstaking exposition on the issue of long‑run in monetary/financial sector and indeed general economics, emerges in the literature. In the meantime, the literature would continue to play host to varieties of models and empirical results on the relationship among monetary aggregates, financial development and economic growth.

oluremi ogun

Department of Economics, University of Ibadan, Ibadan, Nigeria

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ABSTRACT

A synthesis of the literature on the relations among monetary aggregates, financial development and economic growth is presented. While recent literature has been dominated by neoclassical thinking, the monetary framework that does not limit the channel of effect of policy factors on economic activities has been neglected. Though both approaches have the same goal, they differ in matters of theory and variables of emphasis. The choice of the appropriate framework appears to invite an incisive study of the issue of long‑run.

Keywords: General Economics, Teaching of Economics, History of Economic Thought, Micro Monetary Theory, Monetarism and Real Balance, Macroeconomic Policy Formulation

JEL Classification: A1, A2, B, E4, E6

RIASSUNTO

Moneta, finanza e credito: una rassegna critica

Questo studio presenta una sintesi della letteratura esistente sulle relazioni tra aggregati monetari, sviluppo finanziario e crescita economica. Mentre la letteratura più recente è stata dominata dal pensiero neoclassico, il modello monetario che non delimita l’insieme degli effetti dei fattori politici sull’attività economica è stato trascurato. Benché i due approcci abbiano lo stesso obbiettivo, essi differiscono dal punto di vista teorico e nelle variabili considerate.

La scelta del modello appropriato richiede uno studio più approfondito di lungo periodo.

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Money, Finance and Growth: A Critical Review - Moneta, finanza e credito: una rassegna critica

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