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Finance-Growth Theories and Empirical Methodologies

Finance-Growth Theories and Empirical Methodologies

The essay is to be analytical rather than descriptive. It should reflect a good understanding of the

finance-growth theories and empirical methodologies



In our context today, many argue that financial developments measured in the eyes of a
monetary indicator and credits are imperative in economic growth. These allegations have led
economist to find a balance in the pursuit of financial liberalization for countries to grow faster.
In as much as it may be empirically proven that there is a strong connection between growth and
finance, there is no proper base that ascertains that the two antecedents spur growth. It is against
this background that this paper seeks to explicitly analyze the finance-growth relationship
through an empirical approach that incorporates other methods (Burnside, & Dollar, 2000).
Burnside and Dollar in their attempt to find out the impact of aid on the economy
discovered that aid would only be effective in an economy that has a sound fiscal, trade and
monetary policies. This has caused many donors to only focus their aid on good economic
policies (Burnside, & Dollar, 2000). This dissertation aims to analyze the hypothesis behind aid
as the most efficient agent in the growth of an economy. The paper will also address the impact
that foreign aid intrigues in the economic growth of a country.

The Neo- Classical Model of Exogenous Growth

This approach introduces the components involved in sustaining a positive growth rate of
a country per capita over a period. According to Burnside and Dollar, continual improvements in
technological knowledge that in turn affects the forms of new goods, markets and processes are
critical to sustaining growth. On the other hand, they allege that in the event that a country lacks
technological progress, the fruits are most likely to decrease the impact of economic growth. In
his approach, he describes the production function through a theory below;

Y-F {K} (Burnside, & Dollar, 2000).


In this theory, he explains that K is the capital stock while Y determines the aggregate
stock that is determined only by a given state. This also entails a range of available approaches
under different capital. K is a cumulative indicator that identifies the various capital goods and
includes human, as well as physical capital (Burnside, & Dollar, 2004). This model puts into
assumption the aspects of capital and labour as fully employed. The central purpose of the
cumulative production function is that it diminishes returns to the accumulation of capital.
In order to ascertain that the rate of capital stock increases in a country in a given period,
the Solow and Swan theory is incorporated. This approach assumes that people save a stable
fraction S of their total gross income Y. However, this approach puts into assumption that taxes
are not included in order to identify the national income and output (Burnside, & Dollar, 2004).
A depreciated level of capital stock is connoted as δ. The rate at which capital accumulates is Sy,
while the rate of the old capital that wears out is QK. The rate of the net increase of capital
inclusive of the net investment is;

K=SF (K)-δK (Burnside, & Dollar, 2004).
According to this theory, savings and investments can only be identical when taxes and
government expenditures, and international trade are excluded since they both represent the flow
of income spent on investments goods rather than on consumed goods.
However, in the absence of a growth in technology and technological changes within a
nation, the returns are more likely to diminish, this affecting the state of an economic growth
(İnce, 2011). According to this author, boosting savings with the objective of increasing growth
is considered void since an increase in s will only raise the rate of capital accumulation
temporarily and will not affect the growth rate of a country (Batraga, Brasliņa, & Viksne, 2014).


When S is however increased, the levels of output and capital are likely to increase thus
changing the savings schedule to an increase.

Endogenous Growth Models

The use of endogenous growth model is a main alternative to the neoclassical growth
approach. This model slightly varies from the neoclassical method of growth since it includes a
couple of inputs such as technology, physical capital, human capital, social capital, intermediate
goods, organizational capital and institutional design (Batraga . et al 2014). The increase of
output according to this model changes with the other mentioned inputs, thus making it difficult
to find stability in the linear relationship between investment and growth.
The neoclassical approach depicts that aid fills the financial gap and allows for greater
investment and growth opportunities in a country. However, this assumption only finds base if
the investment is liquidated and constrained and the incentives that should be invested are
favourable (Boreham, 2008). In a nutshell, then the incentives to invest are low, the investments
level also fall low. Aid, on the other hand, may also cause a negative effect on investment
incentives, a factor that could cause a country to seek for more aid in the future. It is, therefore,
imperative to consider the fact that aid can finance consumption rather than investment
(Abdessatar, & Rachida, 2013). Burnside and Dollars allegation that aid increases growth under
a good policy is substantial and does not ascertain if aid can lead to investments.

Theory of Aid and Growth

The standard model that has been in use for years now to justify aid is that of two-gap
model that is attributed to Chenery and Stout. In this approach, the first gap is inferred to as that
between the investment amounts required to achieve a growth rate and the available savings


(Rajan, & Subramanian, 2008). The second gap is that which describes the import requirements
that are needed for a given level of production, inclusive of the foreign exchange earnings. In
this approach, economic growth is tied to the investments as shared in the GDP. This growth is
adjusted to factors that reveal the state of the investment, whether high or low (Hansen, & Tarp,
2001). The amount of investments, therefore, sums the domestic savings and foreign aid of a
In summary, Burnside and Dollar, in their pursuit to find the balance in the relationship
between foreign aid, economy and growth found that aid has a positive impact on growth and
development of a country. This can only be possible is such a country has a good fiscal, trade
and monetary policy and has few pressures on poor policies (Burnside & Dollar, 2000). These
factors can be achieved when empirical ideologies that are growth oriented are introduced.


This dissertation focused on Burnside and Dollar (2000) ideologies that viewed the
relationship between aid and GPA per capita of a country. In as much the results have faced a
wide debate from empirical researches; aid has a significant negative impact on a countries GDP
per capita growth (Gupta, 2004). However, when a good policy environment is cultivated, aid
has a significant impact on the economy of a country. It is important that donors understand and
create frameworks that provide them with better tools to improve developmental agendas in
different countries (Easterly, Ross, & Roodman, 2003).



Works Cited.

Abdessatar, A., & Rachida, B. J. (2013). Institutional Quality and Financial Stress: Experience
From Emerging Country. Studies In Business & Economics, 8(3), 5-20.
Batraga, A., Brasliņa, L., & Viksne, K. (2014). Identification of Innovation Ideas in Its
Development Process. Management of Organizations: Systematic Research, (70), 23-40.
Boreham, G. F. (2008). The Financial Markets Approach to Economic Development in LDCs.
Service Industries Journal, 6(1), 22-41.
Burnside, C., & Dollar, D. (2000). Aid, policies, and growth. The American Economic Review,
90 (4), 847-868.
Burnside, C., & Dollar, D. (2004). Aid, Policies, and Growth: Reply. American Economic
Review, 94(3), 781-784.
Easterly, W., Ross, L., & Roodman, D. (2003). New data new doubts: A comment on burnside
and dollar’s “aid, policies, and growth” (2000). National Bureau of Economic Research
Working Paper Series,
Gupta, K. L. (2004). Foreign capital and domestic savings: A test of Haavelmo’s hypothesis with
cross-country data: A comment. Review of Economics & Statistics, 52(2), 214-216.
Hansen, H., & Tarp, F. (2001). Aid and growth regressions. Journal of Development Economics,
64 (2), 547-570.
İnce, M. (2011). Financial Liberalization, Financial Development and Economic Growth: An
Emprical Analysis for Turkey. Journal of Yasar University, 6(23), 3782-3793.
Rajan, R. G., & Subramanian, A. (2008; 2008). Aid and growth: What does the cross-country
evidence really show? Review of Economics and Statistics, 90 (4), 643-665.

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