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Gorkhmaz Imanov, Ali Ahmadov: Estimation of the Optimal Size of Financial Depth
in Terms of Macro-Stability

On the other hand, Global Fina ncial Crisis of 2008-2009 proved that extreme
financial deepness could potentially create bubbles, prevent proper identification of
risks and financial sector sustainability and increase its sensitivity to shocks. This, in
turn, may negatively affect economic activity.

A lot of existing studies was devoted to non-linear relationship between financial
deepness and economic growth (see for instance, Arcand et al., 2015; Law and
Singh, 2014; Cecchetti and Kharroubi, 2012; Sahay et al., 2015; Imanov 2017). The
majority of these papers have shown that the optimal level of domestic credit to the
private sector in percentage of GDP varies between 80-100% and anything beyond
this level has negative macroeconomic impact.

Financial deepness can be bank-oriented and market-oriented. In the early stage of
economic development, the main driver of the economic growth is banking sector
(bank-oriented financing). Banks finance low risk investments through standard
financial products. Whereas in the transition from developing stage to developed
stage, investors require a broader range of financial instruments to manage risks and
attract capital. In this stage, securities markets play key role to finance complex
investment projects through their non-standard financial mechanism (market based
financial sector).

The rest of the paper will be structured as follows. Section 2 provides a literature review
related to my study. Section 3 is devoted to data and methodological issues. The fourth
section summarizes results of analysis followed by conclusion in section five.

II. LITERATURE REVIEW
There is a broad range of research in economic literature that investigated the market
versus bank-finance: for research in the field of currency crisis see Kaminsky and
Reinhart (1999) and Domac and Martinez-Peria (2003): for research in the field of
deposit insurance see Demirgüç-Kunt and Detragiache (2002); and for research on
development level and dynamic of credit market see Schularick and Taylor (2012).

However, the impact of the development of financial markets, especially that of loan
and stock markets on price stability, is not widely examined. Lee et al. (2011) used
VAR model and found that yields of securities had negligible impact on inflation.

Investigating 15 OECD countries, De Schryder (2017) reviewed the impact of
inflation on crisis and its reaction on decreasing level of leverage in economies. The
author used a hybrid Keynesian Phillips curve and identified that there is an
asymmetric reaction of inflation on output gap (strong when there is overheating of

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