Relationship Between Financial Development and Economic Development

TABLE OF CONTENT

1.Title: A RELATIONSHIP BETWEEN FINANCIAL DEVELOPMENT BY PROVIDING LONG TERM INVESTMENTS AND ECONOMIC
DEVELOPMENT AS INCREASE IN STANDARD OF LIVING ……………………….Pg.3

2.Abstact…………….......................................................................................Pg.3

3.Introduction………………………………………………………………Pg.3-5

4. Economic Issues and Methods………......................................................Pg.5-6

5. Microeconomics and Microeconomics…………. ……………………...Pg.6-7

6.Economic Growth versus Economic Development…………………..……Pg.8

7.Intensive versus Extensive Economic Growth……………......Pg.8

8.Does Growth create Development……………………………Pg.9

9.What Is Finance,Really?........................................................................Pg.10-11

10.How Finance Works..?....................................................Pg.11-13

11.The Three Main Areas Of Finance………………………...Pg.12

12.The Relationship Between Financial And Economic Development…………………………………………………………….Pg.13-15

13.The Functions of the Financial System and Its’ Effects to Economic Development……………………………………….Pg.16

14.Facilitating Risk Amelioration…………………………Pg.17-18

15.Acquaring Information about Investments and Allocating………………………………………………......Pg.18-19

16.Monitoring Managers And Exerting Corporate Control..Pg.19-20

17.Mobilizing Savings…………………………………......Pg.20-21

18.Facilitating Exchange………………………………………Pg.21

19. Methodology………………………………………………………..Pg.22-23

20. Conclusions………..………………………………...…………........Pg.24-25

21. References …………………….…………………………….…........Pg.26-28

22. Glossary …………….………………………………………...…….Pg.29-31

A RELATIONSHIP BETWEEN FINANCIAL DEVELOPMENT BY PROVIDING LONG TERM INVESTMENTS AND ECONOMIC
DEVELOPMENT AS INCREASE IN STANDARD OF LIVING

ABSTRACT:

In today’s global world if everyting( humans life, choices, politics, technology even inter governmental relations) is depend on economics what helps to develop economics and by this way how increase living standards and as a sub-topic of economics how finance plays a role? This paper reviews, appraises, and critiques theoretical and empirical research on the connections between the operation of the financial system and economic development. The empirical literature on finance and development suggests that countries with better developed financial systems experience faster economic development. Financial development - as captured by size, depth, efficiency and reach of financial systems varies sharply around the world, with large differences among countries at similar levels of income. I believe that we will not have a sufficient understanding of long-run economic development until we understand the evolution and functioning of financial systems. This paper argues that a good- functioning financial system is the key factor to occur permanent and healty economic development.

INTRODUCTION

ECONOMISTS hold different opinions regarding the importance of the financial system for economic growth. Walter Bagehot (1873) and John Hicks (1969) argue that it played a critical role in igniting industrialization in England by facilitating the mobilization of capital for “immense works.” Joseph Schumpeter (1912) contends that well-functioning banks spur technological innovation by identifying and funding entrepreneurs with the best chances of successfully implementing innovative products and production processes. In contrast, Joan Robinson (1952, p. 86) declares that “where enterprise leads finance follows.” According to this view, economic development creates demands for particular types of financial arrangements, and the financial system responds automatically to these demands. The inherent functions of financial systems, including mobilising savings to their highest valued use, acquiring information, evaluating and monitoring investment projects, and enabling individuals to diversify away idiosyncratic risk, have been widely believed to encourage productive investment and therefore total factor productivity and economic development (Huang,2005, p.6). Moreover, some economists just do not believe that the finance-development relationship is important. Robert Lucas (1988, p. 6) asserts that economists “badly over-stress” the role of financial factors in economic growth, while development economists frequently express their skepticism about the role of the financial system by ignoring it (Anand Chandavarkar 1992). For example, a collection of essays by the “pioneers of development economics,” including three Nobel Laureates, does not mention finance (Gerald Meir and Dudley Seers 1984). Furthermore, Nicholas Stern’s (1989) review of development economics does not discuss the financial system, even in a section that lists omitted topics. In light of these conflicting views, this paper uses existing theory to organize an analytical framework of the finance-development nexus and then assesses the quantitative importance of the financial system in economic development. Although conclusions must be stated hesitantly and with ample qualifications, the preponderance of theoretical reasoning and empirical evidence suggests a positive, first-order relationship between financial development and economic development. There is even evidence that the level of financial development is a good predictor of future rates of economic growth, capital accumulation, and technological change. Moreover, cross country, case study, industry- and firm-level analyses document extensive periods when financial development— or the lack thereof—crucially affects the speed and pattern of economic development. To arrive at these conclusions, I organize the remainder of this paper as follows. Section І explains basic terms and concepts about economics, economic development and differences between economic development and economic growth to find out the bond and relationship between financial development and economic development. Section II explains what the financial system does and how it affects—and is affected by—economic development. Theory suggests that financial instruments, markets, and institutions arise to mitigate the effects of information and transaction costs. [1] Furthermore, a growing literature shows that differences in how well financial systems reduce information and transaction costs influence saving rates, investment decisions, technological innovation, and long-run growth rates. Section II also advocates the functional approach to understanding the role of financial systems in economic growth. This approach focuses on the ties between development and the quality of the functions provided by the financial system. These functions include facilitating the trading of risk, allocating capital, monitoring managers, mobilizing savings, and easing the trading of goods, services, and financial contracts.[2] Part III then turns to the evidence. While many gaps remain, broad crosscountry comparisons, individual country studies, industry-level analyses, and firm-level investigations point in the same direction: the functioning of financial systems is vitally linked to economic growth. Specifically, countries with larger banks and more active stock markets grow faster over subsequent decades even after controlling for many other factors underlying economic growth. Industries and firms that rely heavily on external financing grow disproportionately faster in countries with well-developed banks and securities markets than in countries with poorly developed financial systems. Moreover, sample country studies suggest that differences in financial development have, in some countries over extensive periods, critically influenced economic development. Yet, these results do not imply that finance is everywhere and always exogenous to economic development. Economic activity and technological innovation undoubtedly affect the structure and quality of financial systems. Innovations in telecommunications and computing have undeniably affected the financial services industry. This paper seeks to pull together a diverse and active literature into a coherent view of the financial system in economic growth.

I.Basic Concepts About Economics and Finance

WHAT IS ECONOMICS?

Economic issues and methods

Economics is one of the social sciences. Any society has to address the problem of how and what to produce for its material survival, and how goods and services which are produced should be distributed among its population. Economists explore how people and institutions behave and function when producing, exchanging and using goods and services. Our main motivation is to find mechanisms which encourage efficiency in the production and use of material goods and resources, while at the same time producing a pattern of income distribution which society finds acceptable. (http://homepage.newschool) Many of the problems which dominate our newspaper headlines are economic problems. Why are some countries poor with very low growth rates while a small number of countries enjoy high living standards and high growth rates? What is the role of international trade, and the movement of capital from one country to another with these global inequalities? Why are some countries more successful at creating employment or reducing unemployment than other countries? Within countries, why do some people earn so much more than others, and what are the best ways to tackle and reduce poverty? Is it possible to pursue economic growth and still protect our natural and physical environments? How should governments try to raise the finance needed to pay for health and education services and income support programmes? What is the proper role for government in the economy? Calling economics a social science also reflects the way economists analyse problems, in that economists aim to develop theories of human behaviour and test them against the facts. These theories are summarised in economic models which define the relationships between variables which we believe best explain the events we observe. An important part of the work of an economist is collecting and analysing observations about economic phenomena - prices, employment, costs, Gross Domestic Product - what we call data. The art of the economist is to blend together theory, data and statistical techniques to arrive at a new understanding of economic problems or to make policy recommendations which hopefully will improve the welfare and living standards of our society.
Microeconomics and Macroeconomics A fundamental feature of the world we live in is scarcity. We cannot all of us have all of the things we would like all of the time, we are forced to make choices. Economics studies the way society organises itself to make choices about what goods and services to produce (how do we decide how much food to produce versus how many houses or how many haircuts?). It also studies how we produce these goods and services (how firms are organised) and who receives these goods and services (the distribution of income). In modern industrialised societies most of these decisions are made through markets. For example, food markets link together consumers shopping in supermarkets with farmers who produce food; if consumers increase their demand for organic foods, food markets send this signal (in the form of a higher price) to provide an incentive to farmers to switch to growing more organic food. Other examples of markets in a modern economy are financial markets (which link savers and investors), labour markets (which link employers and employees), the housing market (which links those looking for housing accommodation with the builders of houses or the suppliers of rented accommodation), transport markets (which link travellers with those providing transport services), energy markets (which link energy suppliers with consumers of energy) and exc. Microeconomics is that branch of economics which studies the behaviour of individual markets and of decision-makers - consumers and firms - within these markets. Each individual market has its own unique characteristics, determined in part by the degree and nature of government regulation. Think of the Dublin taxi market, or the market for charter holidays, or the market for legal services. What determines prices in these markets? Do these markets work efficiently? Is the nature of government intervention in these markets appropriate? These are the sorts of questions asked by microeconomists. (http://economics.about.com) The other main branch of economics is macroeconomics. Macroeconomics is concerned with the behaviour and functioning of the whole economy. Macroeconomists work with questions such as what determines the overall growth rate of an economy and what policies would be effective in trying a raise an economy's growth rate? What determines the overall rate of price inflation in any economy and how might governments try to maintain price stability? Macroeconomics became the dominant interest of economists between the 1950s and 1970s largely due to two factors: first, the development of national income accounts which allowed us to systematically measure national economic performance for the first time; and secondly, that governments had both the duty and the ability to stabilise the growth of the overall economy in order to avoid both damaging recessions and high unemployment, on the one hand, and inflation and price increases, on the other hand. Today, many economists have lost faith in the ability of governments to successfully intervene in a discretionary way at the macroeconomic level, but this remains an area of active debate and research among the economics profession.

Economic Growth versus Economic Development

“What is the meaning growth if it is not translated into the lives of people..?” United Nations Development Program, Human Development Report,1995.

Economic development refers to social and technological progress. It implies a change in the way goods and services are produced, not merely an increase in production achieved using the old methods of production on a wider scale. Economic growth implies only an increase in quantitative output; it may or may not involve development. Economic growth is often measured by rate of change of gross domestic product (eg., percent GDP increase per year.).Gross domestic product is the aggregate value-added by the economic activity within a country's borders. (Todaro and Smith, p.15) Economic development typically involves improvements in a variety of indicators such as literacy rates, life expectancy, and poverty rates. GDP does not take into account important aspects like leisure time, environmental quality, freedom, or social justice; alternative measures of economic wellbeing have been proposed. (http://en.wikipedia.org) A country's economic development is related to its human development, which encompasses, among other things, health and education.

Intensive versus Extensive Growth

A closely related idea is the difference between extensive and intensive economic growth. Extensive growth is growth achieved by using more resources (land, labour and capital). Intensive growth is growth achieved by using a given amount of resources more efficiently (productively). Intensive growth requires development. (http://en.wikipedia.org)

Does growth create development?

Dependency theorists argue that poor countries have sometimes experienced economic growth with little or no economic development; for example, in cases where they have function mainly as resource-providers to wealthy industrialised countries. There is an opposing argument, however, that growth causes development because some of the increase in income gets spent on human development such as education and health. (http://en.wikipedia.org) According to Ranis (2000), we view economic growth to human development as a two-way relationship. Moreover, Ranis suggested that the first chain consist of economic growth benefiting human development with GNP. Namely, GNP increases human development by expense from families, government and organizations like NGOs. With the increase in economic growth, families and individuals will likely increase expenditures with the increased in incomes, which leads to increase in human development. Further, with the increased in expenditures, health, education tend to increases in the country and later will contribute to economic growth. In addition to increasing private incomes, economic growth also generate additional resources that can be used to improve social services (such as healthcare, safe drinking water etc...). By generating additional resources for social services, unequal income distribution will be limited as such social services are distributed equally across each community; benefiting each individual. Thus, increasing living standards for the public. To summarize, as noted in Anand’s article (1993), we can view the relationship between human development and economic development in three different explanations. First, increase in average income leading to improved in health and nutrition (known as Capability Expansion through Economic Growth). Second, it is believed that social outcomes can only be improved by reducing income poverty (known as Capability Expansion through Poverty Reduction). Thirdly, (known as Capability Expansion through Social Services), defines the improvement of social outcomes with essential services such as education, health care, and clean drinking water. (http://en.wikipedia.org)

What Is Finance, Really?

Finance is a subfield of Economics. It deals with the allocation of wealth through time: the decision of how much to consume today and how much to save or invest for consumption tomorrow. The field is divided into two basic disciplines. Corporate finance, which involves the identification of optimal investment strategies for firms and how they should be financed, and Investments, which deals with the myriad of securities (stocks, bonds, options, etc.) and strategies available to investors to reach their financial goals. Since finance deals with future values, it necessarily deals with the formation of expectations and investor behaviors. A bourgeoning area within the discipline is behavioral finance, which incorporates issues from psychology and the social sciences. (Todaro and Smith,p.741-742) The financial sector connects savers and borrowers – providing “intermediation services”. You want to save for retirement and would obviously like your savings to earn a respectable rate of return. I have a business idea but not enough money to make it happen by myself. So you put your money in the bank and the bank makes me a loan. Or I issue securities – stocks and bonds – which you or your pension fund can buy. In this view, finance is win-win for everyone involved. And financial flows of some kind are essential to any modern economy at least since 1800.Unfortunately, two hundred years of experience with real world finance reveal that it also has at least three serious pathologies can derail an economy. First, the financial sector often get or aspires political power. The fact that banks have a great deal of cash on hand always makes it easy to buy some political favors, and to get privilege and power for big financial enterprises. President Andrew Jackson had exactly this struggle with the Second Bank of the United States in the 1830s. (http://baselinescenario.com) Second, the financial sector can obtain disproportionate power over industry. The “money trust” idea of the early 20th century may have been somewhat exaggerated – money cannot be corralled as effectively by private players as can, say, copper or steel – but there is no doubt that 100 years ago, Wall Street banks dominated the process of consolidating railroads and of creating pernicious industrial trusts. Trust-busting required taking on the country’s most powerful financiers. (http://baselinescenario.com) Third, finance can also go crazy, running up speculative frenzies. Which kind of financial sector pathologies do we face today? Unfortunately: all of the above. And, not just in nature but also in size, we face a financial sector much more potentially debilitating than anything. In our previous showdowns with finance, the sector was small. During the nineteenth century, the value of financial intermediation services was no more than 1 or 2 percent of GDP. With the growth of a much bigger and more diversified economy after World War II, there was some increase in financial activity as a share of GDP, but the big jump came after the deregulation of the 1980s. Just a few years ago, finance accounted for an astonishing – and unprecedented for the US – 40 percent of all corporate profits, and even today the sector generates around 7% of what we measure as GDP.

Does finance make a difference . . .? Raymond Goldsmith (1969, p. 408)

HOW FİNANCE WORKS..? Finance is the science of funds management. The general areas of finance are business finance, personal finance, and public finance. Finance includes saving money and often includes lending money. The field of finance deals with the concepts of time, money and risk and how they are interrelated. It also deals with how money spent and budgeted. Finance works basically through individuals and businesses with depositing money in a bank. The bank then lends the money out to other individuals or corporations for consumption or investment, and charges interest on the loans. Loans have become increasingly packaged for resale, meaning that an investor buys the loan (debt) from a bank or directly from a corporation. Bonds are debt sold directly to investors from corporations, while that investor can then hold the debt and collect the interest or sell the debt on a secondary market. Banks are the main facilitators of funding through the provision of credit, although private equity, mutual funds, hedge funds, and other organizations have become important as they invest in various forms of debt. Financial assets, known as investments, are financially managed with careful attention to financial risk management to control financial risk. Financial instruments allow many forms of securitized assets to be traded on securities exchanges such as stock exchanges, including debt such as bonds as well as equity in publicly-traded corporations. Central banks act as lenders of last resort and control the money supply, which affects the interest rates charged. As money supply increases, interest rates decrease. (http://www.financeprofessor.com)

[pic]
|Financial Management |Financial Markets & Institutions |Investments |
|Financial management is the study and |This includes money markets (short-term|Employment is usually found |
|practice of making dollar*-denominated |debt) and capital markets (long-term |in one of three areas: |
|decisions within a single firm, i.e., |debt and equities). Money markets |a) sales, |
|microfinance. Most job opportunities in |provide companies and governments with |b) security analysis and |
|finance are in financial management; |liquidity, and the capital markets |portfolio management, or |
|every company needs a financial manager, |provide the same entities with |c) financial planning. |
|even a one-person operation. Financial |long-term capital. Typical financial |Typical firms are stock |
|managers are concerned with the |institutions are commercial banks, |brokerages, commercial banks,|
|acquisition and allocation of financial |investment banks, thrifts, insurance |investment companies (mutual |
|resources for a company. They spend most |companies, and credit unions. |funds), and insurance |
|of their time managing working capital | |companies. |
|(short-term assets and liabilities). | | |
|*Or yen or Euros, etc. | | |
|People employed in any one of the three main areas of finance must be familiar with the workings of the other |
|two. All three areas strongly interact . |

Figure 1 (http://courses.dsu.edu/finance)

II. The Relationship Between Financial Development and Economic Development

The empirical literature on finance and development suggests that countries with better developed financial systems experience faster economic growth. Financial development - as captured by size, depth, efficiency and reach of financial systems varies sharply around the world, with large differences among countries at similar levels of income.

What is the role of the financial sector in economic development? Economists hold very different views. On the one hand, prominent researchers believe that the operation of the financial sector just respond to economic development, adjusting to changing demands from the real sector. On the other hand, equally prominent researchers believe that financial systems play very important role at alleviating market frictions and hence influencing savings rates, investment decisions, technological innovation and therefore long-run growth rates.

1.Financial markets and institutions arise to mitigate the effects of information and transaction costs that prevent direct pooling and investment of society’s savings. 2.While some theoretical models stress the importance of different institutional forms financial systems can take, more important are the underlying functions that they perform. Financial systems help mobilize and pool savings, provide payments services that facilitate the exchange of goods and services, produce and process information about investors and investment projects to enable efficient allocation of funds, monitor investments and exert corporate governance after these funds are allocated, and help diversify, transform and manage risk.(Andersen, S,p.13) While still far from being conclusive, the bulk of the empirical literature on finance and development suggests that well-developed financial systems play an independent and causal role in promoting long-run economic growth. More recent evidence also points to the role of the sector in facilitating disproportionately rapid growth in the incomes of the poor, suggesting that financial development helps the poor catch up with the rest of the economy as it grows.If finance is important for development, why do some countries have growth-promoting financial systems while others do not? How do we define financial development? And what can governments do to develop their financial systems? (Todaro and Smith,p.742-743)
[pic]
Figure 2. A Theoretical Approach to Finance and Growth(Levine,R,p.691)

Figure2,discusses how specific market frictions motivate the emergence of financial contracts,markets, and intermediaries and how these financial arrangements provide five financial functions that affect saving and allocations decisions in ways that influence economic growth.

The Functions of the Financial System and Its’ Effects to Economic Development The costs of acquiring information and making transactions create incentives for the emergence of financial markets and institutions. Financial markets and institutions may arise to ameliorate the problems created by information and transactions frictions. Different types and combinations of information and transaction costs motivate distinct financial contracts, markets, and institutions. In arising to cure transaction and information costs, financial systems serve one primary function: they facilitate the allocation of resources, across space and time, in an uncertain environment. To organize the vast literature on finance and economic activity, I break this primary function into five basic functions. Specifically, financial systems
- facilitate the trading, hedging, diversifying, and pooling of risk,
- allocate resources,
- monitor managers and exert corporate control,
- mobilize savings, and
- facilitate the exchange of goods and services. (http://www.cmi.no/publications)

How particular market frictions motivate the emergence of financial markets and intermediaries that provide these five functions?

On capital accumulation, one class of growth models uses either capital externalities or capital goods produced using constant returns to scale but without the use of nonreproducible factors to generate steady-state per capita growth.In these models, the functions performed by the financial system affect steady-state growth by influencing the rate of capital formation. The financial system affects capital accumulation either by altering the savings rate or by reallocating savings among different capital producing technologies.On technological innovation, a second class of growth models focuses on the invention of new production processes and goods.(Levine,R.,p.691)

A.Facilitating Risk Amelioration and its effects to economic development In the presence of specific information and transaction costs, financial markets and institutions may arise to ease the trading, hedging, and pooling of risk. This subsection considers two types of risk: liquidity and idiosyncratic risk... Liquidity is the ease and speed with which agents can convert assets into purchasing power at agreed prices. Thus, real estate is typically less liquid than equities, and equities in the United States are more liquid than those traded on the Nigerian Stock Exchange. Liquidity risk arises due to the uncertainties related with converting assets into a medium of exchange. Inform asymmetries and transaction costs may inhibit liquidity and intensify liquidity risk. These frictions create incentives for the emergence of financial markets and institutions augment liquidity. With liquid capital markets, savers can hold assets—like equity, bonds, or demand deposits—that they can sell quickly and easily if they seek access to their savings. Simultaneously, capital markets transform these liquid financial instruments into long-term capital investments in illiquid production processes. Deposit-taking banks can provide liquidity by issuing liquid demand deposits and making illiquid, long-term investments. Isolating this liquidity function from the other financial functions performed by banks, however, has proven prohibitively difficult. Stock markets, financial intermediaries—coalitions of agents which combine to provide financial services—may also enhance liquidity and reduce liquidity risk. Diamond and Dybvig’s (1983) model assumes it is prohibitively costly to observe shocks to individuals, so it is impossible to write incentive compatible state-contingent insurance contracts. Under these conditions, banks can offer liquid deposits to savers and undertake a mixture of liquid, low-return investments to satisfy demands on deposits and illiquid, high-return investments. By providing demand deposits and choosing an appropriate mixture of liquid and illiquid investments, banks provide complete insurance to savers against liquidity risk while simultaneously facilitating long-run investments in high-return projects. Banks replicate the equilibrium allocation of capital that exists with observable shocks. By eliminating liquidity risk, banks can increase investment in the high-return, illiquid asset and accelerate growth. There is a problem that banks will only emerge to provide liquidity if there are sufficiently large impediments to trading in securities markets. (Levine,R.,p.691) Besides reducing liquidity risk, financial systems may also mitigate the risks associated with individual projects, firms, industries, regions, countries, etc. Banks, mutual funds, and security markets all provide vehicles for trading, pooling, and diversifying risk. The financial system’s ability to provide risk diversification services can affect long-run economic growth by altering resource allocation and the saving rates. Besides liquidity risk, the financial system also provides mechanisms for hedging and trading the idiosyncratic risk associated with individual projects, firms, industries, sectors, and countries. While a vast literature examines the pricing of risk, there exists very little empirical evidence that directly links risk diversification services with long-run economic growth. Moreover, the only study of the relationship between economic growth and the ability of investors to diversify risk internationally through equity markets yields inconclusive results. One common weakness in empirical work on liquidity, idiosyncratic risk, and economic growth focuses on equit markets. Bond markets and financial intermediaries may also provide mechanisms for diversifying risk. Indeed, technological, regulatory, and tax differences across countries may imply that different financial structures arise to provide liquidity and risk diversification vehicles. For example, in one economy the cost of establishing an mediator may be high while the costs of conducting equity transactions are low. The reverse may hold in a second economy. The first economy may provide liquidity and risk diversification services primarily equity markets, while the second does it financial intermediaries. The first economy has an active stock exchange, so that existing empirical studies would classify it as providing substantial liquidity and risk diversification services.(Andrianova,S.,and P. Demetriades,p.11-19) In contrast, existing studies would classify the second economy as financially underdeveloped. Thus, measuring the performance of one part of the financial system may generate a misleading indicator of the functioning of the whole financial system.

B. Acquiring Information About Investments and Allocating
Resources
It is difficult and costly to evaluate firms, managers, and market conditions. Individual savers may not have the time, capacity to collect and process information on a wide array of enterprises, managers, and economic conditions. Savers will be unwilling to invest in activities about which there is little reliable information. Consequently, high information costs may keep capital from flowing to its highest value use. The ability to acquire and process information can have important growth implications. Because many firms and entrepreneurs will solicit capital, financial intermediaries, and markets are better at selecting the most promising firms and managers will induce a more efficient allocation of capital and faster growth. Besides identifying the best production technologies, financial intermediaries may also boost the rate of technological innovation by identifying those entrepreneurs with the best chances of successfully initiating new goods and production processes. Stock markets may also influence the acquisition and dissemination of information about firms. As stock markets become larger and more liquid, market participants may have greater incentives to acquire information about firms. Intuitively, with larger more liquid markets, it is easier for an agent who has acquired information to disguise this private information and make money. Thus, large, liquid stock markets can stimulate the acquisition of information. Moreover, this improved information about firms should improve resource allocation substantially with corresponding implications for economic growth.

C. Monitoring Managers and Exerting Corporate Control Consider, for example, the simple assumption that it is costly for outsider investors in a project to verify project returns. This creates important frictions that can motivate financial development. Insiders have incentives to misrepresent project returns to outsiders. Given verification costs, however, it is socially inefficient for outsiders to monitor in all circumstances. With “costly state verification” (and other assumptions including risk-neutral borrowers and verification costs that are independent of project quality), the optimal contract between outsiders and insiders is a debt contract. Specifically, there is an equilibrium interest rate, r, such that when the project return is sufficiently high, insiders pay r to outsiders and outsiders do not monitor. When project returns are insufficient, the borrower defaults and the lenders pay the monitoring costs to verify the project’s return. These verification costs impede investment decisions and reduce economic efficiency. Verification costs imply that outsiders constrain firms from borrowing to expand investment because higher leverage implies greater risk of default and higher verification expenditures by lenders. Thus, collateral and financial contracts that lower monitoring and enforcement costs reduce impediments to efficient investment (Levine,R,p.695) Besides reducing duplicate monitoring, a financial system that facilitates corporate control “also makes possible the efficient separation of ownership from management of the firm. This in turn makes feasible efficient specialization in production according to the principle of comparative advantage”. The delegated monitor arrangement, however, creates a potential problem: who will monitor the monitor? Savers, however, do not have to monitor the intermediary if the intermediary holds a diversified portfolio (and agents can easily verify that the intermediary’s portfolio is well diversified). With a well-diversified portfolio, the intermediary can always meet its promise to pay the deposit interest rate to depositors, so that depositors never have to monitor the bank. Thus, well-diversified financial intermediaries can foster efficient investment by lowering monitoring costs. Furthermore, as financial intermediaries and firms develop long-run relationships, this can further lower information acquisition costs. The reduction in information asymmetries can in turn ease external funding constraints and facilitate better resource allocation. In terms of long-run growth, financial arrangements that improve corporate control tend to promote faster capital accumulation and growth by improving the allocation of capital.(Andrianova, and Demetriades, p.31-35) Similarly, if takeovers are easier in well-developed stock markets and if managers of under-performing firms are fired following a takeover, then better stock markets can promote better corporate control by easing takeovers of poorly managed firms. The threat of a takeover will help align managerial incentives with those of the owners. I am not aware of models that directly link the role of stock markets in improving corporate governance with long-run economic growth.

D. Mobilizing Savings

Mobilization—pooling—involves the agglomeration of capital from disparatesavers for investment. Without access to multiple investors, many production processes would be constrained to economically inefficient scales. Furthermore, mobilization involves the creation of small denomination instruments. These instruments provide opportunities for households to hold diversified portfolios, invest in efficient scale firms, and increase asset liquidity. Without pooling, household’s would have to buy and sell entire firms. By enhancing risk diversification, liquidity, and the size of feasible firms, therefore, mobilization improves resource allocation. (Levine,R., p.698) Mobilizing the savings of many disparate savers is costly, however. It involves (a) overcoming the transaction costs associated with collecting savings from different individuals and (b) overcoming the informational asymmetries associated with making savers feel comfortable in relinquishing control of their savings.(Quartey, Peter, p.96) Financial systems that are more effective at pooling the savings of individuals can profoundly affect economic development. Besides the direct effect of better savings mobilization on capital accumulation, better savings mobilization can improve resource allocation and boost technological innovation. Thus, by effectively mobilizing resources for projects, the financial system may play a crucial role in permitting the adoption of better technologies and thereby encouraging development.

E. Facilitating Exchange Easing savings mobilization and thereby expanding the of set production technologies available to an economy, financial arrangements that lower transaction costs can promote specialization, technological innovation, and growth. The links between facilitating transactions, specialization, innovation, and economic growth were core elements of Adam Smith’s (1776) Wealth of Nations. Smith (1776, p. 7) argued that division of labor specialization—is the principal factor underlying productivity improvements. With greater specialization, workers are more likely to invent better machines or production processes. The critical issue for our purposes is that the financial system can promote specialization. Adam Smith argued that lower transaction costs would permit greater specialization because specialization requires more transactions than an autarkic environment. Information costs, however, may also motivate the emergence of money. Because it is costly to evaluate the attributes of goods, barter exchange is very costly. Thus, a recognizable medium of exchange may arise to facilitate exchange. Modern theorists have attempted to illuminate more precisely the ties between exchange, specialization, and innovation (Greenwood and B. Smith 1997). More specialization requires more transactions. Because each transaction is costly, financial arrangements that lower transaction costs will facilitate greater specialization. In this way, markets that promote exchange encourage productivity gains. There may also be feedback from these productivity gains to financial market development. If there are fixed costs associated with establishing markets, then higher income per capita implies that these fixed costs are less burdensome as a share of per capita income. Thus, economic development can spur the development of financial markets.(Khasnobis and Mavrotas, p.123)

METHODOLOGY Goldsmith (1969) asked whether (1) financial development influences economic development and whether (2) financial structure – the mix of financial markets and intermediaries operating in an economy -- affects economic development. Recently, empirical research has expanded the study of financial structure to a much broader set of countries. Demirguc-Kunt and Levine classify countries according to the degree to which they are bank-based or market-based. They also examine the evolution of financial structure across time and countries. They find that banks, nonbank financial intermediaries (insurance companies, pension funds, finance companies, mutual funds, etc.) and stock markets are larger, more active, and more efficient in richer countries and these components of the financial system grow as countries become richer over time. Also, as countries become richer, stock markets become more active and efficient relative to banks. As other emprical researchs, this paper examines literature review about financial developments impacts on economic development. There are many literature review try to find out what the relation of economics and finance but there is a difference in my research. All other theories are set the economic growth theory between financial development and economic development. But this paper acted as exploratory research contucted for financial instruments and their roles in the economy and to understand how these instruments play a role to maintain economic development.

Another area should consider to investigate where there has been recent empirical research is the impact of financial development on income distribution and poverty. Theory provides conflicting predictions in this area. Some theories argue that financial development should have a disproportionately beneficial impact on the poor since informational asymmetries produce credit constraints that are particularly binding on the poor. In fact, poor people find it particularly difficult to fund their own investments internally or externally since they lack resources, collateral and political connections to access finance. Developed economies can sustain a better life to poor and by technology improvements they can get more chance to make their life better. Technology innovation, may only foster growth in the presence of a financial system that can evolve effectively to help the economy exploit these new technologies. Furthermore, technological innovation itself may substantively affect the operation of financial systems by, for example, transforming the acquisition, processing, and dissemination of information. Moreover, the financial system may provide different services at different stages of economic development, so that the financial system needs to evolve if growth is to continue. My theory suggests that financial systems influence development by easing information and transactions costs and thereby improving the acquisition of information about firms, corporate governance, risk management, resource mobilization, and financial exchanges. . Yet others argue that financial access, especially to credit, only benefits the rich and the connected, particularly at early stages of economic development and therefore, while financial development may promote growth, its impact on income distribution is not clear Finally, if access to credit improves with aggregate economic development and more people can afford to join the formal financial system, the relationship between financial development and income distribution may be non-linear, with adverse effects at early stages, but a positive impact after a certain point.

By understanding concepts of financial instruments, how they behave in the economy and how they can help to improve financial developments we can reach to economical development standards. Using literature review as a method for understanding what is going on actually in the finance is a good way to bring on the table what was happened in the history before. But this qualitative research does no take into account “Growth” issue to understand development of the economy like recent researches. It explains what is economic growth. And it is still debate growth provides economic development. We need some quantitative methods like panel and time-series estimation techniques, or firm-level and industry-level data to calculate economic growth. In this paper I used qualitative methods. As I mentioned before dependency theorists argue that poor countries have sometimes experienced economic growth with little or no economic development; for example, in cases where they have function mainly as resource-providers to wealthy industrialised countries. Using debatable method does not be honest and true way for readers to prove your theory. At this point I think we should consider the rights of readers and right to have true information of people. By the way when the subject is ethichs, I would like to talk about plagiarism which is very important issue for literature review. It is good to read more and more but the main point is to use your own word and your own voices. I get help about ethics from Economic and Social Research Council’s Research Ethics Framework for my research.

CONCULISIONS

I suggest that financial sector development plays an independent and causal role in promoting long-run economic development. A good financial system means that a system which fulfill all of its functions that are facilitating risk betterment, acquaring information about investments and allocating, monitoring managers and exerting corporate control; mobilizing savings; facilitating exchange. Facilitating risk occurs with providing liquidity. Liquidity is the ease and speed with which agents can convert assets-what are financial instruments as equity, demand deposits, bonds- into purchasing power at agreed prices to seek access to their savings. If you can’t do this,it means that your financial system is not developed and effectual and if your country’s financial system can’t provide liquidity, liquidity risk eventuates. For example the US stock market is more and more liquid than Nigerian stock market. It is more easier convert assets to liquid in US stock market. Economic development doesn’t just need to short-term high or low return projects or investments and also needs long-term investments. There, a developed financial system and its functions occurs here. Because you have to have allocation of resources, liquidity, savings and providing continuous capital for making long-term investments to provide development. By these features, financial instruments as banks, mutual funds, and securities markets all provide vehicles for trading, pooling, and diversifying risk. Deposit-taking banks can provide liquidity by issuing liquid demand deposits and making illiquid, long-term investments. By providing demand deposits and choosing an appropriate mixture of liquid and illiquid investments, banks provide complete insurance to savers against liquidity risk.

Furthermore, financial systems’ development means that your system doesn’t impose some medium or small events or negativities wherever happen in the world or in your country. So, people can invest and save more and easily because of having secure, healty and easy doesn’t change equity and capital market and stock market. Also investors, firms, individuals, countries don’t loose huge amount of money suddenly. The other sample characteristic of well-functioning financial system is mobilizing savings. Mobilization-pooling-means that collection of capital from different savers for investment. Many of production process will be economically inefficient without access to multiple investors. Financial systems that are more effective at pooling the savings of individuals can profoundly affect economic development. Moreover, by the direct effect of better savings mobilization to capital accumilation, better savings mobilization will improve resource disposition and technological innovations. So, by mobilization of savings for projects and investmens, financial development play an important role to adoption of technological innovations and to encouraging economic development. In the same way, facilitating goods and service exchange as a function of developing finance that effects to economic development. If an economy has avaliable circumstances to expanding new production technologies, financial regulations on low transaction cocts and facilitating savings mobilization, that economy can provide technological innovation, specialization, economic development. With greater specialization, workers are more likely to invent better machines or production processes. More specialization requires more transactions. Because each transaction is costly, financial arrangements that lower transaction costs will facilitate greater specialization. In this way, markets that promote exchange encourage productivity gains. So, financial development occurs with fulfillment of its functions. The fulfillment of system functions provides and encourages entrepreneurs’s, investors’s, savers’s and firms’s and institusions’s investments, savings, transactions and exchanges in a healty, easy and secure condition. It provides long-term high return investments to individuals and organizations, and reduces risk. İndividuals and organizations, who can improve their savings and capitals with both banks and any other financial instruments, do more transactions and investments. This provides country’s economic development and growth in long-term period. Developed economic and financial systems means that well income and well living standards.

REFERENCES
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Jim Janke,October 29,2011 http://courses.dsu.edu/finance/major/whatis.htm

http://www.financeprofessor.com/introcorpfinnotes/whatisfinance.htm http://www.jstor.org GLOSSARY OF TERMS

Capital Investment: Money invested in a business venture with an expectation of income, and recovered through earnings generated by the business over several years. It is generally understood to be used for capital expenditure rather than for day-to-day operations (working capital) or other expenses.

Financial capital: which represents obligations, and is liquidated as money for trade, and owned by legal entities. It is in the form of capital assets, traded in financial markets.
Idiosyncratic Risk: [pic]The risk of price change due to the unique circumstances of a specific security, as opposed to the overall market. Risk that is firm-specific and can be diversified through holding a portfolio of stocks. This risk can be virtually eliminated from a portfolio through diversification. also called unsystematic risk.
Information Asymmetries: Condition in which at least some relevant information is known to some but not all parties involved. Information asymmetry causes markets to become inefficient, since all the market participants do not have access to the information they need for their decision making processes. opposite of information symmetry

Liquidity: 1. A measure of the extent to which a person or organization has cash to meet immediate and short-term obligations, or assets that can be quickly converted to do this.
2. Accounting: The ability of current assets to meet current liabilities.
3. Investing: The ability to quickly convert an investment portfolio to cash with little or no loss in value.

Medium of Exchange: Any item that is widely accepted in exchange for the goods and services offered to consumers in a given market. One example of a medium of exchange is currency.
Mobility of Capital: Ability of the private funds to move across national boundaries in pursuit of higher returns. This mobility depends on the absence of currency restriction on the inflows and outflows of capital In the emerging global knowledge economy a country’s ability to build and mobilize knowledge capital, is equally essential for sustainable development as the availability of physical and financial capital. (World Bank, 1997) The basic component of any country’s knowledge system is its indigenous knowledge. It encompasses the skills, experiences and insights of people, applied to maintain or improve their livelihood.
Reference: World Bank, (1997) "Knowledge and Skills for the Information Age, The First Meeting of the Mediterranean Development Forum"; Mediterranean Development Forum, URL: http://www.worldbank.org/html/fpd/technet/mdf/objectiv.htm

Panel Data Analysis: is a method of studying a particular subject within multiple sites, periodically observed over a defined time frame. Within the social sciences, panel analysis has enabled researchers to undertake longitudinal analyses in a wide variety of fields. In economics, panel data analysis is used to study the behavior of firms and wages of people over time.

Risk Amelioration: Amelioration can mean avoidance of risk or the reduction of risk. As the presence of risk indicates uncertainty then we can reduce risk by increasing certainty .

Skepticism: is a methodology, not a position on matters. It is a way of examining claims and making decisions. The idea is to apply the rules of logic and reason with critical thinking skills in assessing claims or issues and to form conclusions based on evidence, not on personal preference or prejudice. These methods make it more likely that those who use skepticism will reach correct conclusions on issues; which, of course, can be of great benefit in all walks of life: personal, business, health matters, recognising scams and misleading claims, finance, etc.

Time-series Estimation Techniques: Trend forecasting (extrapolation) techniques (such as autoregression analysis, exponential smoothing, moving average) based on the assumption that 'the best estimate for tomorrow is the continuation of the yesterday's trend.' TSA is more suitable for short-term projections and is used where (1) five to six year's time series data is available and (2) where relationships between different values of a variable and their trend is clear and relatively stable. Instead of building a cause-and-effect (causal) model, TSA aims to isolate the sources of variations in a set of data so that their effect on a variable can be determined.

Transaction Costs: 1. A fee charged by a financial intermediary such as a bank, broker, or underwriter.
2. Economics: The cost associated with exchange of goods or services and incurred in overcoming market imperfections. Transaction costs cover a wide range: communication charges, legal fees, informational cost of finding the price, quality, and durability, etc., and may also include transportation costs. Transaction costs are a critical factor in deciding whether to make a product or buy it. Also called frictional cost. See also transfer cost.

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[1]These frictions include the costs of acquiring information, enforcing contracts, and exchanging goods and financial claims.
[2] For different ways of categorizing financial functions, see Cole and Betty Slade (1991) and Robert C. Merton and Zvi Bodie (1995).

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Financial markets and intermediaries

Growth

Channels to growth
- capital accumulation
- technological innovation

Financial functions
- mobilize savings
- allocate resources
- exert corporate control
- facilitate risk management
- ease trading of goods, services, contracts

Market frictions
- information costs
- transaction costs