Financial development and innovation-led growth

The purpose of this master's thesis is to study the effects of financial development on economic growth and investigate whether the impact differs between advanced and emerging economies. In addition, the study explores whether it matters for growth if the financial system is bank-based or market-based. As the main theoretical frame-work, the thesis introduces a simple Schumpeterian multisector growth model with credit constraints. The model explains why further development of different financial systems can enhance innovation-led growth, and also why a country’s distance to the technological frontier can affect its growth rate and how financial development is related to it. The results of the empirical study show that financial development is positively and significantly related to economic growth, but the relationship appears to be bell-shaped; financial development affects growth positively at low levels, but after a certain threshold the impact is vanishing or even turns negative. The results are in line with earlier literature. The study also suggests that to facilitate growth in advanced economies, it is beneficial to develop financial markets, whereas emerging economies benefit most from the overall financial development. The development of financial institutions might have a negative impact on growth in advanced economies. The results confirm earlier findings of the convergence effect; financial deepening can help a country converge to the growth rate of the frontier, but it does not affect steady-state growth.