Financial Development
Demand factors

That financial development is important for growth and capital accumulation is now well recognised. A better financial market makes the allocation of savings to investment more efficient and may increase savings if it is positively correlated with their returns. Empirical evidence on the impact of financial development on real activity is reasonably robust and convincing. The historical record suggests that economic development is associated with the rise of the financial sector. This rise is often triggered by exogenous events such as large budget deficits generated by wars or the availability of large investment projects such as railroads. In Discussion Paper No. 1160, Research Fellow Gilles Saint-Paul discusses the role played by such demand factors in financial development and how they favour growth.

In the three instances of increased public debt, large-scale privatization, and large investment projects, financial development is driven by `demand', that is, a need to bring together large amounts of savings. Using a simple macroeconomic model to discuss the role of demand factors in financial development, the author finds that an increase in public debt temporarily crowds out physical investment, but has long-run positive effects on growth, as long as the economy remains in a regime where the amount of savings available to the private sector is constrained by the level of financial development. Similar results hold with large-scale privatization and large investment projects, although the latter have much lower crowding-out effects in the short run. Furthermore, there may be multiple equilibria and a temporary increase in public borrowing may trigger a shift of the economy from an equilibrium with low financial development to an equilibrium with high financial development.

Demand-Driven Financial Development
Gilles Saint-Paul

Discussion Paper No. 1160, April 1995 (IM)