Quantifying the Impact of Financial Development on Economic Development

Abstract

How important is financial development for economic development? A costly state verification model of financial intermediation is presented to address this question. The model is calibrated to match facts about the U.S. economy, such as intermediation spreads and the firm-size distribution for the years 1974 and 2004. It is then used to study the international data, using cross-country interest-rate spreads and per-capita GDP. The analysis suggests a country like Uganda could increase its output by 140 to 180 percent if it could adopt the world's best practice in the financial sector. Still, this amounts to only 34 to 40 percent of the gap between Uganda's potential and actual output.

Keywords: costly state verification, economic development, financial intermediation, firm-size distribution, interest-rate spreads, cross-country output differences, cross-country TFP differences

JEL Classification: E13, O11, O16