The Effects of Financial Sector Development on Innovation as an Engine of Sustained Growth

The finance-led growth hypothesis states that financial development promotes economic growth by enhancing either efficiency of capital accumulation or technological innovation or both. A typical strategy to test the validity of the hypothesis is to regress measures of financial development on aggregate growth measures such as GDP per capital growth. This type of approach is problematic because of simultaneity. Furthermore, the channel of influence from the financial sector to the real sector is not specified. This paper focuses on the innovation channel of influence and tests whether financial development positively affects the rate of technological innovation. By focusing on a specific channel of influence, simultaneity is ameliorated. Using a panel of patent application data of developing countries as a proxy for technological innovation, this paper provides evidence that financial development seems to be an important determinant of the rate of technological innovation across countries and over time.