Financial development and economic development

The "financial system" includes banks, stock markets, insurance companies, and other financial institutions. "Financial development" means that the financial system is fairly large and performs the important functions described below:

1. It provides financing for large firms so they can expand their scale and implement complex technologies. That is possible as the financial system pools together the savings of various individuals and small firms and can finance large projects.

2. It evaluates the prospects of different investments and allocates financing to the most promising ones. In that way, the available funds in the economy are put to good use.

3. It monitors whether the funds are used prudently and as intended.

4. It helps savers diversify risk. Banks and stock markets pool together the savings of thousands of individuals and invest them in many projects. That lowers the risk to individuals because the funds are spread out across many different investments.

Notice the increase of bank credit in the world economy over the last decades.

Of course, the financial system may or may not perform well the functions described above. If it does, the real economy grows. If it doesn't, then economic growth stagnates or we may even experience a financial crisis.


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