How can financial development reduce poverty?

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There are many nations in the world where people suffer from extreme poverty. It has been a massive challenge for politicians and economists to come up with solutions to this issue. Many financial experts have presented many models over the years but none have really worked out very well, not on a global scale at least. However, there is an idea that the financial development of a nation as a whole can lead to an improvement in the lifestyles of the poorest in that nation.

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This is an interesting idea to discuss as reducing poverty has to be given as much importance as possible. Even college students who may be tasked with writing an essay about poverty should be aware of such theories and research papers. If students start talking about this issue in their academic settings more, then such ideas can be shared widely with the leaders of tomorrow.

So, how exactly can economic success help to reduce poverty?

Background of the Research

This idea has been presented by three economists, Asli Demirguc-Kunt, Ross Levine, and Thorsten Beck. In this research paper, they have outlined how growth in a country’s finances can lead to a fall in income inequality, thus improving the income of the poor. They state that when a country progresses more rapidly in terms of its economy, then those who have very little end up growing quicker than otherwise.

This is a surprising discovery as it has been confusing for a long time as to whether the financial improvement of a country actually helps reduce poverty or not. While it has been clear that it does lead to better economic growth, its effects on the poorest class of a country were never really very clear.

Two Competing Theories

There have been two main theories regarding this matter.

  • The first theory claims that one reason for the increasing divide between the rich and the poor is inadequate information and transaction costs, etc. that are very difficult for the less fortunate to take care of since they don’t have connections, credit histories, and collaterals. Therefore, when the country grows financially, it leads to the alleviation of these issues by easing credit constraints and improving the allocation of capital.
  • The second theory claims that those who don’t have much usually rely on family connections for financial support and that any improvements that take place in the financial sector help the rich. Therefore, as a result of increased financial success, income inequality would increase even further as it would affect primarily the income of the rich.

 

The New Research

The three researchers have analyzed both theories under the lens of formal financial development. They have collected data regarding the economies of developing countries as well as those that are developed, from 1960 to 1999. This data has been used to find out if there is any connection between growth and the changes in income distribution.
On the other hand, they also gathered information on developing countries from 1980 to 2000 to test if changes in a country’s economy lead to poverty alleviation.

The author measured the private credit ratio of the different economic classes to determine the results of their research. The two examples that illustrate their point are Chile and Peru.

  • In Chile, where the private credit ratio is high at 54%, it was seen that the percentage of those who had less than $1 per day to live reduced by 14% annually.
  • In Peru, where the private credit ratio is low at 13%, it was seen that the percentage of those who had less than $1 per day to live increased by 19% annually.

 

This is a big difference. The authors of the research also projected that if Peru had the same kind of development that Chile had at the time, then the number of those living in very poor conditions would have increased by only 5%. This would have equated to the percentage of Peruvians living for less than $1 per day to be just 2% by the year 2000 instead of 15% which it actually was.

Conclusion

The findings of this working paper show how it is possible to lower poverty levels in a country if the finance sector grows overall. Income inequality reduces as a result of this growth and the positive effect can be seen clearly, as this research finds. Therefore, if poverty reduction and minimizing income inequality between various classes is important, countries should focus on the success of their finance sector.

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