Finance and poverty : evidence from fixed effect vector decomposition

In this paper we attempt to distinguish the direct effect of financial development on poverty reduction from its indirect effect through economic growth. Using an efficient estimator called fixed effect vector decomposition (FEVD) we employ a set of panel data from 54 developing countries for the period 1993–2004. Our results indicate that on average financial development is conducive for poverty reduction but the instability accompanying financial development is detrimental to the poor. The major policy recommendations suggested by the paper indicate that financial sector reforms should be directed at easing credit restrictions while taking into consideration the effects of financial instability on the poor.