NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH
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Financial Development, Growth, and Crisis: Is There a Trade-Off?

Norman Loayza, Amine Ouazad, Romain Rancière

NBER Working Paper No. 24474
Issued in April 2018
NBER Program(s):Economic Fluctuations and Growth Program, International Finance and Macroeconomics Program

This paper reviews the evolving literature that links financial development, financial crises, and economic growth in the past 20 years. The initial disconnect—with one literature focusing on the effect of financial deepening on long-run growth and another studying its impact on volatility and crisis—has given way to a more nuanced approach that analyzes the two phenomena in an integrated framework. The main finding of this literature is that financial deepening leads to a trade-off between higher economic growth and higher crisis risk; and its main conclusion is that, for at least middle-income countries, the positive growth effects outweigh the negative crisis risk impact. This balanced view has been revisited recently for advanced economies, where an emerging and controversial literature supports the notion of "too much finance," suggesting that there might be a threshold beyond which financial depth becomes detrimental for economic growth by crowding out other productive activities and misallocating resources. Nevertheless, the growth/crisis trade-off is alive and strong for a large share of the world economy. Recognizing the intrinsic trade-offs of financial development can provide a useful framework to design policies targeting financial deepening, diversity, and inclusion. In particular, acknowledging the trade-offs can highlight the need for complementary policies to mitigate the risks, from financial macroprudential policies to monetary policy frameworks that monitor the growth of credit and asset prices.

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Document Object Identifier (DOI): 10.3386/w24474

Published: "Finance in the Real Economy: Evidence from the U.S." in Handbook of Finance and Development p289-311

 
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