Links Between Stock Markets and Economic Growth

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Townsend’s (1979) study was motivated in part by questions of optimal regulation of financial institutions such as intermediaries, and it suggests a simple theory of intermediation and avoid the difficulties associated with non-convex technologies using a game theoretic approach “non-cooperative game theoretic model”, and it is described in which exchange is motivated by risk sharing considerations. Through liberalization of interest rates and other restrictive; equity markets may improve allocation efficiency. On another hand, if the economy does not include equity market, then more government invention is necessary for financial system and advanced approaches are required (Cho, 1986).

Levine (1991) argues that stock markets affect growth in two ways. The first involves firm efficiency and depends on the externality in human capital production. Stock markets increase firm efficiency by eliminating the premature withdrawal of capital from firms. This accelerates the growth rate of human capital and per capita output. The second way stock markets can affect growth is to raise the fraction of resources devoted to firms. This does not necessarily depend on externalities but by increasing the liquidity of firm investment, reducing productivity risk, and improving firm efficiency, stock markets encourage firm investment. This stimulates human capital production and growth. Holmstrom and Tirole (1993) emphasize that a firm's ownership structure influences the value of market monitoring through its effect on market liquidity. Considering an agent holds some fraction of the firm as a long-term investment. If he decides to decrease his ownership, there will be more shares actively traded and the liquidity of the market will go up. Wit...

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... And they investigate that the liquidity of financial markets affect the choice of capital production technology, per capita income and per capita capital stock, the level of financial market activity, the real return on saving, and welfare of steady state equilibrium.

By pooling and diversifying risks, by increasing liquidity or by reducing monitoring costs, financial markets and institutions are believed to have a positive impact on growth because they divert investments towards more productive activities or increase the flow of savings (Blacburn and Hung, 1998).

Levine (1997) illustrates the role of finance in the growth by comparing between German bank-based system and United States securities market-based system. Which is called the “Functional Approach “. Levine argue that financial system

• Facilitate the trading hedging, diversifying, pooling of risk.