EFFECTS OF FINANCIAL DEVELOPMENT ON ECONOMIC GROWTH IN THE UK

Document Type:Dissertation

Subject Area:Economics

Document 1

Different variables have been used. The test of the hypothesis is based on the significance of the controlled variables using the F test and the T test of the regression model. All the data comes from the World Bank website and therefore are not hypothetical values. The literature review looks at relevant papers on the topic, and draws from the opinions of other research, to find the effect of finance development and its relationship to economic growth in the UK over the time. Previous studies show that there is a strong correlation between financial market development and economic growth. The argument has however remained a debatable subject matter with different scholars giving different points of view. The argument by Favara (2003) states that financial development and growth of the economy lays its basis on the average effects that can’t be understood by layman language.

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Research done by Levine (2005) states that empirical and theoretical evidence makes it hard to come up with a conclusion that financial systems automatically respond to the economic activities taking place in a particular country. Also, development of financial system is an unimportant addendum during the economic growth process. Schumpeterian and neo Keynesian scholars give unequivocally proclaimed abilities on the banking sector in relation to creation of money and channeling the money into production and innovation (Graff, 2003). The trailblazing work done by King and Levine (1993) gives a hint of the relationship on bases of financial development and economic growth nexus. Even though the empirical results show that the key factors that determine the growth of the economy is the development of effective and efficient financial system, there may be contingency on particular political, social cultural, economic and geographical phenomenon.

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Different literatures give a summary that there are four possibilities that give a casual relationship between the development of finance and economic growth (Apergis et al. One of the examples is the supply leading response hypothesis which provides an argument that the cause of economic growth is the development of financial systems (Schumpeter, 1911, McKinnon, 1973 & Shaw, 1973). The second hypothesis is the demand following hypothesis, which argues that the growth of the economy hastens the development of financial system in an economy. A survey done by Rioja and Valev (2004) (a survey that involved 74 countries) confirms that various phases of economic development that involve generalized method of moments (GMM) estimation, affects the financial development and the growth of an economy generally depend on financial sector development.

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Various schools of thought concur with McKinnon- Shaw hypothesis, explicating by using models of services rendered by financial intermediaries like the provision of liquidity and sharing of risks. The school of thought by King and Lavine (1993b) uses the endogenous growth model where the financial intermediaries get information data on firms or individual projects that in most cases are not available to the private sector or public market. The proposal made by Lavine (1997) indicates that the development of financial systems facilitate the growth of an economy. Lavine (1997) proposal indicates that the economic growth contributes by the development of financial system is two way channeled; through capital accumulation and innovation in technology. The central theme is that it is vital to have a system of finance that is well developed to boost growth.

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The growing body of empirical papers encompasses three approaches that examine the positive relationship. The three approaches include the cross country studies, the firm industry level studies and individual country studies. The Cross Country Studies It incorporates the seminal work of Goldsmith (1969). Gold smith used the data from 35 countries. Levine and King (1993) give some of the evidence for 80 third world countries over the years 1960 to 1989. Their survey is based on examination of production growth channels. Other factors that have an influence on the growth of an economy were put into control. In addition, Levine and King used four measures of financial development that are more reliable than the measures that were used by Goldsmith. Levine and King (1993 b) made a survey with the objective of determining the financial depth value of 1960, prediction of the growth of the economy and improvement in productivity in 60 years.

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This is an indication that the roles that stock markets have in providing financial services is different from the role that banks have. In another study, Levine, Loayza and Beck (2000) assessed the link growth of the relationship between the financial sector and industrial development. They did a cross country regression. The analysis was done using seventy nations for five years. They concluded that there was a connection between financial and industrial growth. For this reason, the method does not give room for several countries to have different causality patterns. The validity of causality is based only on average. Additionally, the cross country growth regression model indicates some weakness due to errors. These errors include; measurement errors, conceptual errors and statistical errors that are made during collection of data.

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The other issue is that the different factors keep on changing over time. However, the financial sector of Tunisia was still underdeveloped. The government of Tunisia should ensure that they make plans to develop their financial sector if they want to boost their economic growth. It can do this by ensuring that more and more financial instruments are made available. A particular study was conducted by Lee and Wong (2005) to assess the effect that inflation has on economic growth in Japan from 1970 to 2001. They claimed that there was a link between financial development and industrial growth impacted by price hike of commodities in Japan. The financial growth nexus tested by Rajan and Zingales (1998) that focused the significance of differential cost of a firm indicated that there is an association between the financial growth rate and the financial system development.

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The empirical study done by De Gregorio and Guidotti (1995) that investigated the association between the financial development and the growth rate of an economy found a strong negative correlation between the two variables. The explanation for the case was based on extreme liberalization of financial markets. This negative correlation was also found by Berthélemy and Varoudakis (1998). The experiment conducted by Berthélemy and Varoudakis (1998) on investigation of the relationship between the financial system and economic growth used panel data that was based on a set of 82 countries over a period of 30 years. The proponents stated above argue that a combination of these market failures cause inefficient allocation of savings. Therefore, bank mitigate of these failures by long-term association with certain firms.

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The proponents of market-based system concentrate on the weaknesses of bank-based systems. Market-based systems argue that large banks encourage businesses to take conservative business ideas. As a result there is tendency to extract large rents from firms consequently leaving them with low surplus. This also applies to indicators of competitiveness and the efficiency of any financial institution. The work on Goldsmith (1969) was the first to indicate the existence of the positive relationship between the financial development and the GDP per capita. The work of King and Levine (1993) utilized monetary indicators and measurements of size. Also they used the relative significance of institutions of banking; in their survey a positive relationship between the two variables was recorded. The survey done by Levine and Zervos (1996) included the stock market development measures.

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(2005) found that the development of financial system relate to the growth effects positively in the short run and not in the long run. Their survey involved an examination of 33 countries where 11 of the countries involved economies on transition and the other 22 countries were market economies. Fink et al. (2008) also carried an investigation on the effect of credit, bond and the stock segments in the EU accession economies during four years of transition in 1996-2000. A comparison between market economies and economies in the intermediate stage was done. Theory about the relationship between financial development and economic growth A financial system is made of financial institutions and financial markets. Financial institutions include banks while the financial markets are characterized by bond markets and stocks.

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A well planned financial system can increase the speed at which physical capital is accumulated. Financial development on the other hand is said to boost activities which are innovative and lead to efficiency. Demirguc-Kunt and Levine (2008) argue that the role of financial development is to lessen information and to all the transactions expenses that hinder economic growth and its functions. When financial institutions diversify risks in firms and industries, they have an impact in allocations of resources hence boost economic growth. d) Mobilization and pooling of savings It involves getting savings from a large number of people which result to large amounts that can be able to finance large investments. The financial systems who can mobilize the savings and have a large amount of savings are in a better position to lead to a very high investment and a quick way of accumulating capital.

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The result is that economic growth is boosted. e) Stimulate innovation, specialization, and growth by reducing costs They can enhance specialization and growth through the reduction of transaction costs. A poor geographical location may give yield to poor crops and may also have unstable supply of water. d) Other factors Other factors include religion, language, ethnicity, income, and population. Research makes a consideration of the banking sector in over 23 economies (Huang, 2010). In consideration of the banking sector, research reveals that the per capita GDP level and saving rate had positive effects on the system of the bank. This can be measured using the assets and numbers. The analysis focuses on different data in order to achieve the following a. Examination of short run dynamics and long run causality between the financial and economic growth in United Kingdom.

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b. To find out the causal correlation between the stock market and the growth of economy in UK using a series of data. c. The method also takes financial markets and intermediaries into account. The model accounts for financial functions, mobilize savings, it also exerts corporate control, allocates resources, the method ease risk management and lastly it facilitate the trading of commodities and contracts. The model also takes into account on channels that led to growth, accumulation of capital and innovation of technology (Levine, 1997). The Levine model basically uses four economic development measures and this paper uses this model in stage 1 of empirical tests. To improve the Levine model, there will be an addition of a few financial indicators to have a comprehensive measure and a precise association between the economic growth and the growth of financial system, these factors are not present in the model that was developed by Levine (1997) but are also significant in the development of an economy.

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This model will be used to estimate the intercepts which are the coefficients of dummy variables. The strength of this model is that it allows the variation of intercept for every cross sections thus it is accountable to the individual effects. The last model that will be used in this paper is error component model (ECM) this model is also called The Random effect model (REM). This model takes the intercept as the random variables and not as fixed constants. The assumption of this model is that the intercepts are independent to the error term and are mutually independent. One of the disadvantages of this measure is that the measure of effectiveness of the financial sector may contain errors especially in the informational asymmetries and in the facilitating of the costs of transactions.

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Another weakness is that the financial institutions include the deposits that involve double counting. The method operate on the assumption that the financial intermediary size correlate with provision and services in the financial sector. The correction between the above variables is assumed to be positive. Due to this assumption most of the researchers use this measure of financial depth (Goldsmith1969; King and Levine 1993a; and McKinnon 1973). Financial depth refers to the level at which the financial markets have developed. The level of financial depth is calculated by dividing M1 which is the summation of money circulating in the economy and demand deposits, and M2 refers to the summation of M1, saving accounts and time deposits. The value gotten from this ration is an indicator of the long term significance of banking and the level of sophistication of the financial market in question.

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The other measure used in this survey is the credit aggregate. The credit aggregates involves the credit in the private sector, credit in the public sector in respect to the gross domestic product and the central bank credits to the finance sector, which inform is a percentage of the domestic credit. Data and calculations Variable year Gross domestic product per capita(GDPC) Stock traded stock value(000) (STV) Inflation consumer prices % (CPI) Government final consumption expenditure(GCP) % Domestic credit to the private sector (DCPC) Market capitalization of listed domestic companies (0) (DMC) Net incurrence of liabilities (NLT) % 1998 23916 63. 51 This data is retrieved from https://data. worldbank. org/ [Accessed 13 Mar. From the above data the regression model will be in form of Due to complexity of the regression model, the values of better are calculated using the SPSS software.

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95 S. D. dependent var 5870. 238 Sum squared resid 2. 85e+08 S. 5302 rho 0. 680274 Durbin-Watson 0. 678979 The above the regression model will be as follows The above model is also refers as the standard model of economic growth. The main purpose of this model is to provide a measure of economic efficiency and development. The model provides an estimate of economic growth in time t for the united kingdom. In our case we test if the change of the response variables affects the GDPC. The test statistic in our case is F test. The rejection criteria will be based on rejection of null hypothesis if the F calculated is greater than the critical value of F F = (MSR/MSE) =(( 2. 85e+08)/20)/(( 4678. 09E+04 Comparing the above value with the critical value of F= 2.

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To test the above hypothesis the usual F – statistics test is used. Thus F = (MSR/MSE) =(( 2. 85e+08)/20)/(( 4678. 09E+04 From the test, we fail to reject the null hypothesis. Among many other indicators in the model the regression model indicate that the initial GDP per capita has a negative effect on the growth rate of an economy. The result from the survey indicates that there is a multilateral causal relationship between the growth of an economy and the development of a financial system. The use of the regression model discussed above does not apply to all the economies. For this reason it is more critical to consider the differences in the financial and economic systems in a country under study. The decisions that are made by an economy depends mainly on the effects of an economic indicator to an economy and how significant a decision it to the future of the economy.

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For this reason the application of this model in the United Kingdom may be applicable which is not the case to developing countries. , Sova, A. and Sova, R. Financial Development and Economic Growth: Evidence from 10 New European Union Members.  International Journal of Finance & Economics, 20(1), pp. Data. (1996), Does Financial Development Cause Economic Growth? Time Series Evidence from 16 Countries, Journal of Development Economics, 5(2), 87-411. Demirgüç-Kunt, A. , & R. Levine. Finance, Financial Sector Policies, and Long-Run Growth. Review of Development Economics, 3 (3), 310-322. Goldsmith, R. Financial Structure and Development. New Haven,CT: Yale University Press. Graff, M. Haslag, J. and Koo, J. Financial Repression, Financial Development and Economic Growth. Federal Reserve Bank of Dallas working paper. Huang, Y. G. & LEVINE, R. (1993a) Finance and growth: Schumpeter might be right.

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