Financial Development and Economic Growth at Different Income Levels

By Cody Kallen. Washington University of St. Louis.

This paper examines the effects of financial development on growth rates using a sample of countries at different points in time, with the observation for each country beginning at the year it reaches a GDP per capita of $10,000 in constant 2005 dollars. This sampling method controls for simultaneity bias due to endogeneity of financial sector development with levels of GDP per capita as well as heterogeneous effects of financial development on growth across income levels. I regress the countries subsequent long-term growth rates on measures of initial financial sector development and a set of control variables. I repeat this for GDP per capita thresholds of $5,000 and $15,000. I find that a larger banking sector has positive and significant effects on growth for upper middle income, marginally significant effects for high income, and insignificant effects for lower middle income countries. I find evidence of nonlinearity in the relationship between financial development and growth across different income levels, as the coefficient estimates decrease as the income level increases.

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