Financial Development and Economic Growth: Long‐Run Equilibrium and Transitional Dynamics

Abstract

We analyze the impact of financial development on economic growth. Differently from previous studies that focus mainly on balanced growth path outcomes, we also analyze the transitional dynamics of our model economy by using a finance-extended Uzawa-Lucas framework where financial intermediation affects both human and physical capital accumulation. We show that, under certain rather general conditions, economic growth may turn out to be non-monotonically related to financial development (as suggested by the most recent empirical evidence) and that too much finance may be detrimental to growth. We also show that the degree of financial development may affect the speed of convergence, suggesting thus that finance may play a crucial role in determining the length of the recovery process associated with exogenous shocks. Moreover, in a special case of the model, we observe that, under a realistic set of parameters, social welfare decreases with financial development, meaning that even when finance positively affects economic growth the short term costs associated with financial activities more than compensate their long run benefits.