Economics Update (January-March 1998)

Financial Intermediation and Growth

U ntil recently economists did not seriously question the linkages between the financial and real sides of the economy. This proposition became controversial beginning in the mid-1980s, and lately theoretical and empirical work has examined the issue.

In an article in the Atlanta Fed's Economic Review (Fourth Quarter 1997), Zsolt Besci and Ping Wang show how banks, brokers and other financial intermediaries' efficiency-enhancing roles can be integrated into modern growth theories. The authors also provide an illustrative model that includes current thinking about the ways in which financial intermediaries affect growth.


"Policies such as reserve requirements, interest rate controls, entry limitations and directed credit flows affect growth and interest rates."
By giving individuals or firms access to economies of scale, financial intermediaries allocate capital to its best possible use and enhance economic efficiency. How well financial intermediaries accomplish their functions may explain differences across countries' rates of growth. Policies such as reserve requirements, interest rate controls, entry limitations and directed credit flows affect growth and interest rates. While most of these policies slow or limit growth, there are two exceptions: the quality of investments and growth may increase if entry restrictions cause financial intermediaries to operate at more efficient scales or if directed credit policies are chosen well.

Besci and Wang survey some recent empirical literature, which finds a positive relationship between growth and financial intermediation and shows that financial repression hurts growth. They note that if a country's banks, brokers and the like are not technologically developed, competitive and innovative, then financial intermediation can have a negative impact on growth factors.

The authors caution that more work is needed before policy recommendations can be made. Their results suggest that more attention needs to be paid to the efficiency enhancing role and imperfectly competitive aspects of financial intermediation. Empirical work suggests that financial intermediaries differ across countries in the cost efficiency and the degree of competition they provide. This finding has implications for economic efficiency and maybe, the authors suggest, for growth.

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