Why Does Financial Development Matter

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WHY DOES FINANCIAL DEVELOPMENT MATTER? THE UNITED STATES FROM 1900 TO 1940 BY RAJEEV DEHEJIA AND ADRIANA LLERAS-MUNEY NATIONAL BUREAU OF ECONOMIC RESEARCH WORKING PAPER SERIES MARCH 2003 There is currently no consensus among researchers on the nature of the relationship between financial development and economic growth. While some contend that financial development gives rise to economic growth, some others are of the opinion that the later precedes the former. Yet, there are other schools of thought that suggest that both are independent and that financial development does in fact harm economic growth occasionally. On the backdrop of the above, the authors of this article examined the effect of several components of economic development and their relationship with economic growth in the United States over a forty-one (41) year period, from 1900 to 1940. The research focused on the effects that state-banking regulations like branching and deposit insurance has on economic growth within the period examined. The result of their analysis led them to the conclusion that there was a strong link between financial development and economic growth in the period studied, and that while the former had a significant impact on the later, the effect was not always positive and that the effects of these were lagged. Bank branching was found to have a sustained positive effect on the economy by inducing financial expansion through reduction in transaction costs as banks took advantage of economies of scale and credit creation. Branching also helped banks to diversify geographically. These, they concluded, further led to positive economic outcomes like increased productivity and employment as well as reduced child-labour. On the other hand, deposit insurance was found to have a negative economic outcome because while it reduced the cost of lending to the banks and thus

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