Discussion Paper Series, Chair of Economic Order and Social Policy, Universität Würzburg 133
This paper investigates the causes of the "vanishing effect of finance" detected in recent studies. The results highlight that the negative effect of the financial system on growth is mainly driven by advanced economies, whereas finance is still beneficial for income increases in developing countries. The reason is that finance and growth are associated via a nonlinear relationship, which is due to a fundamental change in the transmission mechanism of finance across different levels of economic and financial development. In early stages of development, finance fosters entrepreneurship, education, and investment in physical capital. As the economies develop, this positive influence vanishes. The negative effect of finance is stronger in countries with sophisticated public education systems, low levels of income inequality, as well as low fertility rates, and in times with low factor productivity growth.