Determinants of the link between financial and economic development: Evidence from a functional coefficient model

•We empirically examine determinants of the finance-development (FD) nexus.•The level of financial development shows a strong positive impact on the FD nexus.•Large governments are associated with a weakened, and sometimes a negative, FD link.•Moderate level of trade openness strengthens the FD link.•Extreme trade openness leads to a negative FD nexus in low- and lower-middle-income economies.

Noting that “one size does not fit all” in the case of the finance-development (FD) relationship, a growing body of literature has recently focused on uncovering economic conditions under which financial development could be beneficial (detrimental) to economic development. We look into these conditions by means of a flexible semiparametric approach that allows the long-run FD link to depend on measurable economic factors. Using annual data for 73 economies spanning the period 1975-2011, we find that the impact of finance on economic development is generally stronger in high-income than low-income economies. However, allowing for intra-group variations reveals the importance of other factor variables in explaining the FD link. For instance, increasing financial development strengthens the FD link while increasing government size weakens it. Moreover, the FD link could even be negative if low- and lower-middle-income economies have very large governments or are extremely open to international trade.