Financial Development as A Determinant of Economic Growth

In the present thesis we examine the effects of capital market restrictions and the extent to which those effects could be analyzed in the context of the Diamond – Dybvig framework. Two novel ingredients are incorporated into the analysis: heterogeneity of the degree to which a given consumer is affected by capital restrictions and the measure of the development of the financial sector in the economy. The former is tied up with the probability of a consumer facing a liquidity shock, while the latter determines the probability of a bank-run that could be a consequence of the consumers’ lack of trust in the banking system.  We further explore the channels through which consumers’ incentives to deposit their funds with the financial intermediary and the structure of the intermediation market are affected by the degree of the financial sector development. Other things equal, a less developed financial sector would induce consumers to invest funds on their own. On the other hand, it is shown that financial sector development adversely affects the desire of financial intermediaries to hold reserves and therefore there is more scope for a bank-run equilibrium to emerge. We then highlight the need for government regulation to ensure the stability of the financial sector. Finally, we establish that the heterogeneity of the extent to which consumers are affected by the capital restrictions does a reasonable quantitative job explaining the magnitude of the drop in the amount of capital available for investment in the economy, while the degree of financial sector development acts as a determinant of the bank-run equilibrium and hence, yields qualitative predictions for the drop in the amount of capital available.