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Summary of Finance


Introduction 2

 Is there an important impact of financial

development on growth?

leading growth-textbooks ignore the financial sector  Merton Miller: there is a very obvious contribution of financial markets to growth  Robert Lucas: role of finance has been overstressed 

 Paper Contents  first part provides overview about theoretical and empirical research regarding above question  second part summarizes historical and policy determinants of financial development

Agenda 3

 summary of paper contents  review of theoretical works  review of empirical works

Term „Financial Development“ information, transaction, enforcement costs

tax, legal, regulatory system

financial contracts, markets, intermediaries

influence on allocation of resources and thus growth

focus on five broad functions of the financial system: (1) (2) (3) (4) (5)


produce information and allocate capital monitor investments and exert corporate governance facilitate trading, diversification and management of risk mobilize and pool savings ease the exchange of goods and services

„Financial Development“ = lower information, transaction and enforcement costs ~ better performance on financial functions

(1) Producing Information and Allocating Capital 5

 large information costs in evaluating of firms,

management and market conditions before granting a loan

Financial Intermediaries bundle efforts and reduce costs (Boyd and Prescott, 1986)  FI produce better information and fund more promising firms and technologies (Greenwood and Jovanovic, 1990)  FI identify better entrepreneurs and innovators (several papers)  large and liquid stock markets set incentives to research for unique information (several papers)  imperfect capital markets impede efficient investment in human capital (Galor and Zeira, 1993) 

(2) Monitoring firms and exerting CG 6

 Corporate Governance determines the degree to

which shareholders can monitor and influence the use of their capital   

asymmetric information principal agent problems „free rider“ problems among minor shareholders

 research on concentrated ownership  research on the role of financial intermediaries  economies of scale in monitoring (Bencivenga and Smith, 1993)  better handling of informational asymmetries (Sussman, 1993; Harrison, Sussman, and Zeira, 1999)  monitoring of innovative activities (De La Fuente and Marin, 1996)

(3) Risk amelioration (cross-sectional risk) 7

ď‚— diversification allows risk-averse investors to

invest in riskier, higher-return investments (Gurley and Shaw, 1955; Patrick, 1966; Greenwood and Jovanovic, 1990) ď‚— diversification can stimulate innovative activity and thus technological change (King and Levine, 1993)

(3) Risk amelioration (liquidity risk) 8

 liquidity = cost and speed of conversion of

financial instruments to purchasing power  some high-return projects require a long-run commitment of capital 

Hicks (1969), Bencivenga, Smith and Starr (1995) on Industrial Revolution Levine (1991) on the effects of liquid capital markets on steady-state growth Bencivenga and Smith (1991) on the role of FI

(4) Pooling of Savings 9

 Pooling = process of agglomerating capital from

many savers for investment 

works on the emergence and role of institutions: investment banks (Carosso, 1970)  banks (Sirri and Tufano, 1995; Boyd and Smith, 1992; Lamoreaux, 1995) 

pooling enables production at efficient scales (Sirri and Tufano, 1995) works by Bagehot (1873)

(5) Easing trade 10

 higher specialization allows for technological

invention and growth (Smith, 1776) requires more transactions  transaction and information costs 

 emergence of money (Smith, 1776; King and

Plosser, 1986; Williamson and Wright, 1994)  Greenwood and Smith (1996) on connections between exchange, specialization, and innovation

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