Financial development and economic growth

We develop a theory of financial development based on the costs associated with the provision of external finance. These costs arise through informati onal asymmetries between borrowers and lenders that are costly to resolve. When borrowing is limited, producers with access to financial intermediary loans obtain higher returns to investment than other producers. This create s incentives for others to undertake the technology adoption necessary to a ccess investment loans. Over time, as increasing numbers of producers gain access to external finance, borrowers' net worth rises relative to debt. Th is reduces the costs of financial intermediation and raises the overall ret urn on investment. The theory is consistent with recent evidence that finan cial development reduces the costs associated with the provision of externa l finance and increases the rate of economic growth. Furthermore, the theor y predicts that financial development will raise the return. on loans and r educe the spread between borrowing and lending rates.