Financial development, real sector, and economic growth

•Non-linear relationship between financial development and growth.•The positive effect of finance on growth depends on the balanced growth of financial and real sectors.•Very rapid financial development can decrease economic growth.

This paper evaluates the interdependence between financial development and real sector output and the effect on economic growth. Using panel data for 101 developed and developing countries over the period 1970 to 2010, we show that the effect of financial development on economic growth depends on the growth of private credit relative to the real output growth. The findings also suggest that the effect of financial development on growth becomes negative, if there is rapid growth in private credit not accompanied by growth in real output. Our findings provide empirical evidence that supports the theories that postulate the existence of an optimal level of financial development given by the characteristics of an economy.