Finance and Productivity Across Income Levels: Unveiling the Heterogeneous Effects of Financial Development

Abstract

The effects of financial market development on improving capital productivity and economic growth have been extensively discussed through endogenous growth models in the economics literature. Financial development can effectively reduce frictions in the economic system and enhance Total Factor Productivity (TFP) growth by improving efficiency and promoting technological progress. However, the impact of financial development on capital allocation is not always positive. Optimal resource allocation can stimulate TFP growth, whereas resource misallocation can hinder it. In other words, at different stages of economic development, financial development has heterogeneous effects on TFP across countries. Therefore, the main issue addressed in this study is how the impact of financial development on TFP is influenced by countries’ income levels. To this end, selected countries were classified into separate income groups, and the relationship between financial development and TFP was examined over the period 2010–2023 using the panel data econometric method in EViews software. The results of the estimated models indicate that the coefficient of the financial development variable is positive and statistically significant in high-income and middle-income countries, with values of 0.0826 and 0.0121, respectively, whereas this coefficient is statistically insignificant in low-income countries. Accordingly, financial development has not been able to improve TFP in low-income countries.