Working Paper Series: Special Edition of 2016 to 2018 Interns

3.0 Literature Review The finance-growth nexus has been a topic of interest over the past decades, as there is a continuous debate on the relationship between finance and economic growth. The link between economic growth and financial innovation has been well studied but remain unclear. The two variables are clearly related, and this relationship has occupied the minds of economists for decades and the direction of causality have remained unsettled in both theory and empirics. This section will conduct a critical review of the literature on financial innovation and economic growth. This will be done in two parts, 3.1 Theoretical Review The underpinning theory of the finance growth nexus can be trace back to Schumpeter (1911). “ Schumpeter was the first drew a strong connection between the innovative performance of an economy and the functioning of its credit and capital markets ” (Muzzucato, 2013). He introduced the term creative destruction 11 which ideally speaks to the fact that innovation can lead to economic growth. He argued that entrepreneurial activity, innovation and large corporations are key determinants of economic growth (Schumpeter (1942) as cited in Muzzucato (2013)). One of the predominant factor of financial innovation is the reduction of transaction cost. This concept was put forward by Hicks & Niehans (1983) 12 , which suggest that financial innovation is a response to technological advancement which leads to reduction in transaction cost. The authors examined the financial innovation for the microscopic economic structure change perspective. They concluded that the driving force for financial innovation was the reduction of transaction cost. Additionally, the reduction in transaction cost can encourage improvement in financial system. Finally, there was theory put forward by Merton (1990), known as the Merton’s market efficiency theory. This theory is based on the idea that financial innovations was designed to improve social welfare and increase market efficiency. Merton (1990) argued that markets are imperfect,

11 Creative destruction refers to the constant product and innovation mechanism by which new production units replace outdated ones (Muzzucato, 2013). 12 As cited in (Mwinzi, 2014)

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