Financial Development and Economic Growth: A New Investigation

By Pan, Huiran; Wang, Chun | Journal of Economic Development, March 2013 | Go to article overview

Financial Development and Economic Growth: A New Investigation


Pan, Huiran, Wang, Chun, Journal of Economic Development


This article applies a Bayesian dynamic factor model to examine the relationship between financial development and economic growth from a new angle. We estimate the common, country, and idiosyncratic factors that drive the dynamics and co-movement of financial development and economic growth across 89 countries in three different income groups, namely industrial countries (INDs), emerging market economies (EMEs), and other developing countries (ODCs), over the period 1970 to 2009. The results indicate that the common factor plays a more significant role in explaining the variance of output growth in INDs and EMEs, but not in ODCs. In contrast, financial development variability is mainly driven by the country and idiosyncratic factors. We also analyze the relation between country characteristics and the relative importance of the factors.

Keywords: Financial Development, Economic Growth, Dynamic Factor Model, Bayesian Analysis

JEL classification: C11, C32, O16

(ProQuest: ... denotes formulae omitted.)

1. INTRODUCTION

Whether financial development boosts economic growth is of great concern to policymakers and researchers, especially after the outbreak of the recent global financial crisis and the European debt crisis. In this context, there are two streams of literature. One argues that a well-developed financial system can make the economy more productive and enhance economic growth. Specifically, a healthy financial system reduces asymmetric information between savers and investors, helps people share risks, and lowers transaction costs. However, there also exists a potential growth-retarding impact of financial development (King and Levine, 1993a), which suggests that higher returns on the improved resource allocation may decrease saving rates and then depress the economic activity. The U.S. financial crisis of 2007-2009 exampled these financial system malfunctions. Lartey and Farka (2011) find that financial crises have a negative effect on economic growth and the impact depends on the level of financial development, such that countries with better developed financial systems are more adversely affected by crises than those with underdeveloped ones.

Recent empirical literature has extensively investigated the relationship between financial development and economic growth. The findings, however, are inconclusive, varying with the econometric models and the data used. Most studies hold the view that there is a significantly positive relationship between financial development and economic growth using various measures of financial development (King and Levine, 1993a, b; Levine et al., 2000; Lartey, 2010; Gupta, 1986, among others). However, Kar et al. (2011) show that there is no clear consensus on the direction of causality between the two variables when using six financial development indicators for the Middle East and North African (MENA) countries. Al-Yousif (2002) finds that financial development and economic growth are mutually causal based on both time-series and panel data of 30 developing countries.

Mixed results are found when using vector autoregressive (VAR) models to study the relationship between financial development and economic growth. For instance, Shan et al. (2001) show the bidirectional causality in five countries and one-way causality from growth to finance in three others when studying nine OECD countries and China. Abu-Bader and Abu-Qarn's (2008) empirical results strongly support the hypothesis that finance leads to growth in five MENA countries. Shan (2005) documents weak evidence of one-way causality from finance to growth in a sample of eight industrial countries and three Asian economies. Esso (2010) and Hassan et al. (2011) have also shown that the causal relationship between finance and growth differs significantly among countries. In addition, using panel VAR analysis, Blanco (2009) finds two-way causality for the middle income group and for countries with stronger rule of law and creditor rights. …

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