Credit vs. payment services: financial development and economic activity revisited

Abstract

The purpose of this paper is to assess whether the banking system, over and beyond its credit function, has a significant impact on per capita GDP by providing means of payment. An annual database of 152 spanning the 1980-2007 period is exploited to this end. On the descriptive front, we find that richer economies display higher and increasing levels of demand deposits and lower levels of currency than poor countries. While this was to be expected, more surprising is the fact that the currency to GDP ratio did not diminish much over time, regardless of income level differences. In turn, our regressions confidently support the hypothesis that banks contribute to economic development not only as credit suppliers but also by facilitating transactions. Specifically, along with the ratio of private credit to GDP, the volume of demand deposits to GDP appears to exert a positive influence on per capita GDP. On the contrary, the level of currency to GDP yields a negative loading. The results are robust to different model specifications and endogeneity tests. These findings have valuable implications for a better understanding of the channels through which the banking system affect the economy.