Interaction between economic and financial development$

This paper presents a model of financial and economic development which assumes the consumption of real resources by the financial sector. Financial development occurs endogenously as the economy reaches a critical threshold of economic development. Compared to financial autarky, financial intermediaries allocate savings, net of their costs of operation, to more productive investments. Whenever the technology financed by intermediaries is more capital-intensive than that operated in financial autarky, the growth effect of financial development is ambiguous. As a result, financial development may be unsustainable. However, when financial development is sustainable, the credit market becomes more competitive and more efficient over time, and this could eventually contribute to economic growth. Nonetheless, given monopolistic competition in the financial sector, the level of entry into the credit market is generally inefficient. For instance, with diminishing returns to specialisation, entrants might be too few at the early stages of economic development and too many later on. r 2006 Elsevier B.V. All rights reserved.