Role of financial markets in the economy:
The role of financial system in economic development has been a much discussed topic among economists. Economists hold dramatically different views. From a much earlier time, Bagehot (in 1873), and Schumpeter (in 1911) argued that an efficient financial system greatly helped a nation's economy to grow. As Ross Levine has pointed out it was Schumpeter's contention that well-functioning banks spurred technological innovation by offering funding to entrepreneurs that have the best chances of successfully implementing innovative products and processes.
More recent economists have been little skeptical about the role of the financial sector in economic growth. Joan Robinson (in 1952) asserted that economic growth created demand for financial institutions and that where enterprise leads finance follows. Robert Lucas (in 1988) has also dismissed the finance-economic growth relationship stating that economists "badly over-stress" the role financial factors play in economic growth.
However, in recent years thanks to the work of Ross Levine, Robert King, and others, economists are again reexamining the role financial markets play in economic growth. On the theoretical side complex models have been developed to illustrate the many channels through which the development of financial markets affect and are affected by economic growth. These channels include the facilitation of trade hedging, diversifying, and pooling of risk; the efficient allocation of resources; the monitoring of managers and exerting corporate control; the mobilisation of savings; and the facilitation of the exchange of goods and services.
On the empirical side a growing body of studies at the firm-level, industry-level, country-level and cross-country comparisons have demonstrated the strong link between the financial sector and economic growth. King and Levines research has The financial system is concerned about money, credit and finance - the terms intimately related yet some what different from each other. It implies a set of complex and closely connected or inter-mixed institutions, agents, practices, markets, transactions, claims and liabilities in the economy. shown that level of financial depth/defined as the ratio of liquid assets to GDP does in fact help to predict economic growth. Other work by Levine has shown that financial intermediary development does positively influence economic growth these results are shown to be robust, that is the relationships still hold when other factors that are known to influence economic growth are held constant.