The Direction of Causality between Financial Development and Economic Growth: Evidence from Turkey

By Demirhan, Erdal; Aydemir, Oguzhan et al. | International Journal of Management, March 2011 | Go to article overview

The Direction of Causality between Financial Development and Economic Growth: Evidence from Turkey


Demirhan, Erdal, Aydemir, Oguzhan, Inkaya, Ahmet, International Journal of Management


In this paper we investigate the causality relationship between financial development and economic growth using available data from 1987:1 to 2006:04 about Turkey. We take total bank credit to private sector and total market capitalization as proxies for financial development and GDP as proxy for economic growth. In this context, Vector Error Correction Model and Impulse Response Functions (IRF) are used to explain possible casual relationships between variables. Empirical findings suggest that there is a bidirectional causality relationship between variables. While the development of the stock market and banking sector has caused economic growth, economic growth has also been brought about by stock market and banking sector developments in Turkey over the same period. Moreover, the contribution of the banking sector to economic growth has been larger than that of the stock market.

(ProQuest: ... denotes formulae omitted.)

Introduction

The different growth rates of countries has preoccupied the minds of economists. The empirical growth literature has found numerous explanations for these differences, such as factor accumulation, resource endowments, the degree of macroeconomic stability, educational attainment, institutional development, legal system effectiveness, international trade, and ethnic and religious diversity. Recently, researchers have focused their attention on financial development to explain the cross-country differences in growth (Khan and Senhadji, 2000).

The origin of financial development and economic growth nexus go back to the work of Schumpeter (1934). He took into account financial intermediaries necessary for innovation and development. According to Schumpeter, it is not possible to explain economic change by previous economic conditions alone. The economic state of a people emerges from the preceding total situations. One of the tools economists use to explain the reason of economic changes is the financial systems of countries. Goldsmith (1969) emphasizes that one of the most important problems in the field of finance is the effect of financial structure and development on economic growth. After Goldsmith's seminal work about 40 years ago, the relationship between financial development and economic growth has been studied by economists for a long time. They have searched the relationship from different perspectives.

Becsi and Wang (1997) explain the finance-growth nexus with financial intermediaries. They emphasize that financial intermediaries give individuals or firms access to economies of scale that they would not have otherwise. Hence, intermediaries affect saving rates (Andrés et al., 2004), facilitate and encourage inflows of foreign capital (DFID, 2004), allocate capital to its most productive use and by this way economic efficiency is enhanced (Becsi and Wang, 1 997; Beck et al., 2000). Also, they play an important role by facilitating the trading, hedging, diversifying, pooling of risk, facilitating the exchange of goods and services (Khan and Senhadji, 2000) and ameliorating asymmetric information (F avara, 2003). How well financial intermediaries carry out their functions may explain different growth rates between countries (Becsi and Wang, 1997). Loayza and Ranciere (2005) searched the relationship between financial development, financial fragility, and growth and used the data of 75 countries. They found that while there is a positive long-run relationship between financial intermediation and output growth, this relationship can be a negative in the short-run. Also, they found that financially fragile countries tend to display significantly negative short -run effects of intermediation on growth.

According to modern growth theory, financial sector might affect long-run growth through its impact on capital accumulation and on the rate of technological progress. Financial sector development has a crucial impact on economic growth and poverty reduction especially in developing countries and without it economic development may be constrained, even if other necessary conditions are met (DFID, 2004). …

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