CHAPTER 5: FINANCIAL STRUCTURE AND ECONOMIC
5.3 Theoretical framework for financial development factors and economic development
The relation between capital market deepening and economic development model framework was formulated by Pagano (1993) from the endogenous growth literature. The fundamental underpinnings of the model lie in a “two factor model” of production comprising capital and
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technology. The model can be extended by incorporating labour with an assumption that population growth is constant.
Pagano’s (1993) model reveals that financial development can affect growth, as it can raise the proportion of savings channelled to investments as well as improve allocation of capital to those projects with the highest level of marginal product. The presence of financial intermediaries, therefore, is important in financing the industrial need to procure more capital and invest in more advanced technology that will enhance chances of fostering higher growth outcomes. In order to capture the potential effects of financial development on economic growth, Pagano (1993) deployed the simplest endogenous growth model, where output is a linear function of aggregate capital stock as:
(5.1)
where: = economic growth, technology and capital stock.
t t
Y AK
Y A K
This production function can be viewed as a reduced form resulting from a competitive economy framework. Production in this case is an increasing function of aggregate capital stock with constant returns to scale technology. To derive the model, he assumes that population is stationary in an economy which produces a single goods. The goods can be either consumed or invested and if invested it will depreciate at the rate of per period. The gross investment will be expressed as:
1 (1 ) (5.2)
t t t
I K K
In a closed economy with no government, capital market equilibrium requires that gross saving, St, equals gross investment, It.Assuming an imperfect financial market, there will be
some proportion of savings, 1-, that will be lost in the process of financial intermediation. The new relationship between investment and savings can be written as:
(5.3)
t t
S I
The amount of savings in an economy can be expressed as a proportion of national output as follows;
(5.3)
t t
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The growth rate of both output and capital at time, t+1, can be expressed as a transformation of equation (5.1) and reported as;
1 1 1 1 1 ( ) 1 ( ) 1, ( ) 1 , where ( ) 1 , (5.4) t t t t t t t t t t t k y g Y Y K K I K K K K K g g g
The expression shown by equation (2.16) entails that the growth in income is directly proportional to the growth in capital stock. The growth rate equation (2.16) can be further decomposed to;
( t t)
g I K , for which from equation (2.12), Kt Y At ; substituting Kt in g, we get:
( ) ; where k y, and (5.5)
gA I Y A s gg g SI sS Y
Equation (5.5) therefore reveals how financial development can affect growth; it can raise, the proportion of savings channelled to investment; it may increaseA, the social marginal productivity of capital; and it can influences, the private savings rate.
In theory, stock markets spur economic growth by increasing both the level and productivity of investment. They increase the savings rate and enhance the efficient allocation of savings. As a result, more savings go to the corporate sector, accelerating economic growth. The extensive evidence favours a positive relationship between stock market development and economic growth. The purpose of this study is to explore the channel that links stock market development and economic growth, recognizing the role of institutions, macroeconomic policies and financial market structure. The extension to Pagano’s (1993) model incorporates the empirical literature results, and the insights and techniques of the endogenous growth model. The endogenous growth models have shown that there can be self-sustaining growth without exogenous technological progress, e.g. Greenwood and Jovanovic, 1990; Bencivenga and Smith, 1991; Saint-Paul, 1992 and Pagano, 1993.
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5.3.1 Extension of Pagano’s model
The extensive empirical literature on the linkages between stock market and economic development by McKinnon (1973), Shaw (1973), Goldsmith (1969), Levine and Zervos (1996), Rajan and Zingales (1998) and others, suggests that a well functioning stock market with good institutions can augment technological innovation and capital accumulation. The study by Wurgler (2000) provides further evidence that even if in some cases financial development does not lead to higher investments; it helps in allocating existing investments better and therefore, indirectly improves economic development.
Along the lines of the model presented in the previous section, the one developed by Pagano (1993), combined with the major empirical evidence, the link between change in savings and financial development becomes:
0 1
( t) ( t) t, where: FD = financial development, s = change in savings
s f FD FD
.
In addition, financial development helps in augmenting the social marginal productivity of capital and this can be expressed as stated below:
0 1
gat f FD( ) (FDt)t; where:gat= social marginal productivity of capital
.
The per capita economic development is a combination of increased savings and the social marginal productivity of capital and therefore becomes;0 1 0 1 0 0 1 1 0 1 0 0 0 ( ) ( ) ( ) (5.6) ( ) ( ) (5.7) where: a y t y t t y t t g f FD FD FD g FD g FD nd 1 11
Recall that one of the aims of this research is to explore mechanisms through which stock market development can affect economic development for emerging and frontier markets. The model that will therefore be tested takes the form of:
( , ),
it
G f SD C where: G = GDP per capita growth (proxy change in economic development), SD = stock market development which replaces financial development, C = control variable
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for other factors that determine economic growth such as human capital development (education), inflation, private investment and savings.