Does Financial Development Reduce the Poverty Gap?

Abstract Financial development may affect poverty directly and indirectly through its impact on income inequality, economic growth, and financial instability. Previous studies do not consider all these channels simultaneously. To proxy financial development, we use the ratio of private credit to GDP or an IMF composite measure. Our preferred measure for poverty is the poverty gap, i. e. the shortfall from the poverty line. Our fixed effects estimation results for an unbalanced panel of 84 countries over the 1975–2014 period suggest that financial development does not have a direct effect on the poverty gap. However, as financial development leads to greater inequality, which, in turn, results in more poverty, financial development has an indirect effect on poverty through this transmission channel. Only if we use poverty lines of 3. 20 or 5. 50 (instead of 1. 90 a day as in our baseline model) to define the poverty gap, we find that economic growth reduces poverty. This implies that in those cases the overall effect of financial development on poverty may be positive or negative, depending on which indirect effect, i. e. that of income inequality or growth, is stronger. Financial instability does not seem to affect the poverty gap. These results are consistent across various robustness checks.