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What Is the Relationship between Financial Development and Economic Growth?

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  • Written By: Esther Ejim
  • Edited By: Kaci Lane Hindman
  • Last Modified Date: 21 November 2016
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The study of the link between financial development and economic growth explores the manner in which financial development contributes to economic development. One way of viewing the relationship between these two is to access the manner in which the human and capital investments can be channeled so that they can produce tangible results that may be channeled toward economic development. Usually, in order for the resultant productivity to be efficiently channeled toward economic development, middlemen in the form of financial institutions have to serve as intermediaries and facilitators.

One of the ways in which financial institutions can help in the facilitation of financial development and economic growth is through the collection of the savings from individuals and households, which may then be redistributed through the provision of credit or loans. The effect of such a practice is to facilitate the procurement of services and goods by consumers, leading to activity on the market and a resulting economic development. An equilibrium in the economy requires a situation where there is a desired balance between the rate of demand in relation to the supply of goods and services by the producers of such products and services. Where the consumers are able to gain access to the means for the payment of purchasing such items, the economy will usually benefit from the financial activities.

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Examples of these activities can be seen where consumers are able to obtain mortgages and other forms of loans and credit in order to purchase homes, cars and other consumables. The resultant activity on the economic front helps to lubricate the engine of economic progress, thus establishing a link between financial development and economic growth. These same financial institutions may also be used to regulate the economy, steering it away from a potential recession and encouraging the growth of the desired positive attributes. An example is the use of high interest rates as a means of slowing down a spiraling growth in the economy, and the reduction of the same as a means for encouraging growth.

Another connection between financial development and economic growth can be seen in the way in which financial institutions are able to foster economic growth through the channeling of needed financial resources to identified areas of the most need. For instance, the savings and other finances may be gathered together and redistributed to the development of projects, which may contribute to the growth of the economy. This also can be enhanced through the monitoring of the loans in order to ensure that they are used for the desired projects.

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