Bank credit | Neo-classical Model and Endogenous Growth Theory

Bank credit | Neo-classical Model and Endogenous Growth Theory 

Credit is the extension of money from the lender to the borrower. Spencer (1977) noted that credit implies a promise by one party to another for money borrowed or goods and services rendered. Credit cannot be divorced from the banking sector as banks serve as a conduct for funds to be received in form of deposits from the surplus units of the economy and passed on to the deficit units who need funds for productive purposes.

Banks are therefore debtors to the depositors of funds and creditors to the borrowers of funds. Bank credit is the borrowing capacity provided to an individual, government, firm or organization by the banking system in the form of loans. According to CBN (2003), the amount of loans and advances given by the banking sector to economic agents constitute bank credit. Bank credit is often accompanied with some collateral that helps to ensure the repayment of the loan in the event of default.

Common argument against bank credit is that banks might tend to “cherry pick” the most-profitable customers, reducing financing to some sectors, increasing the risk exposure of micro-finance banks and these affect the overall distribution of credit. In particular, the main area of concern is the availability of credit to private investors and small businesses.

Neo-classical Model of Growth

The Neo-classical model of growth was first devised by Robert Solow. The model believes that a sustained increase in capital investment increases the growth rate only temporary. This is because the ratio of capital to labour goes up (there is more capital available for each worker to use) but the marginal product  of additional units of capital is assumed to decline and the economy eventually moves back to long-term growth path, with the real GDP growing at the same rate as the workforce plus a factor to reflect improving “productivity”. A “steady state growth path” is reached when output, capital and labour are all growing at the same rate, so output per worker and capital per worker are constant.

Neo-classical economists believe that to raise an economy’s long-term trend rate to growth requires an increase in the labour supply and an improvement in the productivity of labour and capital. Difference in the rate of technological change are said to explain much of the variation in economic growth between developed countries. The neo-classical model treats productivity improvements as an “exogenous” variable meaning that the productivity is assumed to be independent of capital investment (IMF, 2001).

According to Nnanna, Englama and Odoko (2004), based on Solow’s analysis of the American data from 1909 to 1949, he observed that 87.5% of economic growth within the period was attributable to technological change and 12.5% to the increased used of capital. The result of the growth model was that financial institutions had only minor influence on the rate of investment in physical capital and the changes in investment are viewed as having only minor effects on economic growth.

Endogenous Growth Theory

Endogenous growth theory  or new growth theory was developed in the 1980’s by Romer (1986), Lucas (1988) and Rebelo (1991), among other economists as a response to criticism of the neo-classical growth model. The endogenous growth model holds that policy measures can have an impact on the long run growth of an economy (Wikipedia, the free encyclopedia).

The growth model is one in which the long-run growth rate is determined by variables within the model, not an exogenous rate of technological progress as in a neo-classical growth model, jhingan (2006) explained that the endogenous growth model emphasizes the technical progress resulting from the rate of investment, the size of the capital stock and the stock of human capital.

In an endogenous growth model, Nnanna, Englama and Odoko (2004) observed that financial development can affect growth in three ways, which are; raising the efficiency of financial intermediation, increasing the social marginal productivity of capital and influencing the private savings rate. This means that a financial institution can affect economic growth by efficiently carrying out its functions, among which is the provision of credit.