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The relationship between financial development and economic growth:

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European Journal of Scientific Research
ISSN 1450-216X Vol.54 No.4 (2011), pp.522-531
© EuroJournals Publishing, Inc. 2011
http://www.eurojournals.com/ejsr.htm

The Relationship between Financial Development and

Economic Growth: “Econometric Model”

Rengin AK
Yüzüncüyıl Üniversitesi

Ekrem Kara
Gaziantep Üniversitesi
E-mail: ekara@gantep.edu.tr

Abstract

The relationship between financial development and economic growth has recently
become one of the remarkable issues in the economics literature. Some authors state that
economic growth is determined by financial development in this relationship; on the other
hand, the some other, with a different point of view, think that the direction of the
relationship is from economic growth to financial development.
In this study, the short-term and long-term effects of an increase in the financial
development on the growth rate will be tried to be explained with econometric model.

Keywords: Financial Development, Economic Growth.

Introduction
The relationship between financial development and economic growth has long been established both
at theoretical and empirical levels. However, the emergence of new theories of endogenous growth has
indeed renewed interest in the potential role of financial system in promoting economic growth and
development (Ndako, Umar Bida, 2010: 38).
The supply-leading and demand following hypotheses put forward by Hugh T.Patrick regarding
the direction of the relationship between financial development and economic growth has a major role
(Atamtürk, 2005: 100). "Supply-leading has two functions: to transfer resources from traditional (non-
growth) sectors to modern sectors, and to promote and stimulate an entrepreneurial response in these
modern sectors” (Patrick, 1966: 175). As for the demand following approach, developments in real
sector bring about demand, and financial corporations and means mediate to meet the demand. The
demand-following approach implies that finance is essentially passive in the growth process (Patrick,
1966: 175; Aslan and Küçükaksoy, 2006: 28). Some economists accept that financial development is
one of the required conditions to realize a high rate of economic growth (Ahmed and Ensari, 1998:
504-505). From this point of view, financial intermediation contributes to the growth by means of two
important channels: 1-increasing the efficiency of capital accumulation and thus marginal productivity
of capital and 2- increasing the saving rate and thus the investment rate. In other words, financial
development leads to a higher rate of economic growth by increasing the amount of savings and
improving the efficiency of the investments. This point of view is highly supported by the recent
empirical literature (Al-Yousif, 2002:132; Aslan and Korap, 2006).
The Relationship between Financial Development and Economic Growth: “Econometric Model” 523

Another important issue regarding the relationship between financial development and
economic growth is the “McKinnon-Shaw” model. According to McKinnon- Shaw, Levine and King,
several restrictions (financial repression) imposed on the banking system by the government can slow
down the development of the financial system and therefore, can cause negative results on economic
growth. For example, interest rates ceilings, compulsory high-level reserve applications and
compulsory sectoral credit programs are seen as the factors that interrupt the development of a dynamic
and competitive finance sector that will fund the economic growth. Similarly, an operationally
inefficient banking sector, as seen in the latest banking crisis, may cause negative and hardly
recoverable effects on the economic growth (Atindehou AO, 2005: 779; Aslan and Korap, 2006).
According to McKinnon and Shaw, the positive effect of financial liberalization on economic
growth is not limited to increasing its national savings level. Financial liberalization also increases
product variety, service quality of the financial markets and technological developments in these
sectors by allowing them to work in a competitive environment. Additionally, along with financial
liberalization, legal and compulsory reserve ratios will be kept at a low level, and this will enable the
banking sector to carry out its intermediation activities efficiently by decreasing the cost of sources of
funds. Besides all these, getting the opportunity to overcome the credit deficit along with financial
liberalization will prevent the existence of unorganized market emerging in the developing countries
and this situation will provide contribution to the development of the financial system (McKingon,
1973:117; Baş-Dinar, 2009:4).
Calderon and Liu (2003) investigated the relationship between financial development and
economic growth based on the data including 109 developing and industrialized countries for the years
between 1960 and 1994. The results show that there is a positive relationship between financial
development and economic growth for most of the countries; a two-way causality is valid between the
two phenomena; financial depth has a more causality effect in the developing countries when
compared to the industrialized countries. The results obtained from the panel unit-root and co-
integration analysis conducted by Fase and Abma (2003) on 9 south-east Asian countries and by
Christopulous and Tsionas (2004) on a group of developing countries support a one-way and
significant interaction from financial development to economic growth. According to Saint-Paul
(1922), an economy whose financial markets have developed on an advanced level can reach a higher
development level when compared to an undeveloped economy. Beck and Levine (2002) came to the
conclusion by using panel data that stock markets and banks have a positive effect on economic
growth. Caporale et al (2004) investigated the causality relationship between the development of stock
and financial markets and economic growth and found out that a developing stock market which fully
accomplishes its functions would accelerate economic growth by accelerating capital accumulation and
providing better distribution of the resources. In an analysis conducted Aslan and Küçükaksoy (2006)
regarding the Turkish economy, a causality was determined from financial development towards
economic growth (Karagöz and Armutlu, 2007: 2-3).
Levine summarized the relationship between finance sector-economic growth in his article
dated 1997 as follows: (Levine, 1997: 691):
524 Rengin AK and Ekrem Kara

Market friction
• Information costs

• Transaction costs

Financial markets and Intermediaries

Financial functions
• Mobilisation of savings

• Providing information and allocation of resources

• Corporate controls

• Facilitating risk management

Growth channel
• Capital accumulation

• Technological innovations

Economic growth

To sum up, Levine states that the effects of financial intermediaries on economic growth occur
in the following ways (Levine, 1997:668-726; Demir and Ark: 443):
• Mobilization of savings
• Risk management
• Providing information on investment opportunities
• Constant observation of borrowers and lenders
• Facilitating the exchange of goods and services
In another study, Graff (2001) used number of banks and branches of banks per person, the rate
of manpower employed in the financial system and the rate of financial system within the gross
national product as the indicators of financial development in order to investigate the relationship
between financial development and economic growth. As a consequence of research, he put forward
that supply-based financial development could be a suitable behaviour for economic growth (Aktaş,
2006:49).
The Relationship between Financial Development and Economic Growth: “Econometric Model” 525

In recent years, when the studies are considered about the relationship between capital market
and economic growth, it is seen that most of the studies in the literature indicating that there is a
positive relationship between capital market and economic growth are those carried out about the
capital markets of the developed countries. The number of the studies about the rising capital markets
is considerably limited. Moreover, it is not yet clearly determined whether the relationship between
capital market and economic growth is valid for the rising economies since the results of these studies
show conflicting findings. (Yücel, 2009:79).
In the empirical studies about Turkey, there is no consensus regarding the causality relationship
between financial development and economic growth. Kar and Pentecos (2000), in their study,
conclude that financial liberalization has no effect on growth. Artan (2007) found evidence supporting
the same hypothesis as a result of the panel data analysis he conducted on 79 countries (Altunç,
2008:115).

Summary of Some Studies Investigating the Relationship between Financial Development and
Economic Growth

Authors Sample Method Findings

Levine and Developed Horizontal-section The results supporting the hypothesis that financial
Zervos (1998) economies regression development leads economic growth have been found.
Lutiel and Khan A sample of 10 VAR Methodology A two-way relation has been found between financial
(1999) countries development and economic growth.
Kang and Sawada Time series data Internal growth Financial development and commercial liberalization
(2000) for 20 countries sample accelerate economic growth by increasing marginal
utility of human capital investments.
Arestis, 5 developed Time series Development of banks and capital markets speed up
Demetriades and countries analysis economic growth, but during this process banks play an
Luinted (2001) important role.
Arestis (2002) 6 developing Standard Financial liberalization is quite a complex process and
countries econometric the effect of financial development is ambiguous.
techniques
Shan and China sample VAR Methodology A two-way relationship has been found between financial
Jianhong (2006) development and economic growth.
Al-Yousif (2002) 30 developing Time series and It is concluded that there is a two-way causality between
countries panel data analysis financial development and economic growth.
Shan and Morris OECD and Asia VAR and Granger While there is a two-way relationship for some countries,
(2002) countries causality test there is a one-way relationship for the other countries.
Dritsakis and Greece sample VAR Methodology It is concluded that there is a causality relationship from
Adamopoulos financial development to economic growth
(2004)
Shan (2005) 10 OECD VAR Methodology For most of the countries studied, financial development
countries and leads economic growth.
China
Chang and Taiwan sample VAR Methodology Causality from financial development to economic
Caudill (2005) growth has been found. That is, the supply-leading
hypothesis has been verified.
Thangavelu and Australia sample VAR Methodology It is concluded that there is causality from economic
others (2004) growth to the development of financial intermediaries;
however, no evidence has been found showing that the
development of financial markets leads to economic
growth.
Kar and Pentecos Turkey sample VAR and Granger It is concluded that economic growth pioneers the
(2002) causality tests development of financial sector
Artan (2007) A sample of 79 Panel data analysis Financial development negatively affects growth in
countries countries with low-income levels.
526 Rengin AK and Ekrem Kara

- continued

Yapraklı (2007) Turkey sample VAR and Granger A two-way causality has been found between
causality test commercial and financial openness and economic
growth.
Tennant, Kirton Jamaica sample Time series and In comparing the results of our two long-run models, it is
and Abdulkadri panel data analysis evident that while it is important to account for the
(2010) individual functions of the financial sector, some of these
functions are so interrelated that it is counterintuitive to
expect them to have independent effects on economic
growth.
Leitao (2010) The European A Panel Data finding also shows that financial development stimulates
Union Countries Approach the productivity and international trade.
And BRIC (Brazil,
Russia, India and
China)
Adamopoulos Ireland sample VAR Methodology The error correction (EC) term, picks up the speed of
(2010) adjustment of each variable in responseto a deviation
from the steady state equilibrium.
Source: Altunç, 2008:116

Aslan and Küçükaksoy (2006), in their study, investigated the causality dimension of the
relationship between financial development and economic growth in Turkey by using the annual data
covering the period 1970-2004. Granger causality tests indicate that the direction of the relationship
between finance and growth is from financial development to economic growth and presented evidence
supporting supply-leading hypothesis.

Empirical Analysis
The Relationship between financial development and growth may show differences from period to
period and from country to country. Therefore, investigating this relationship is an empirical subject.
When literature is researched, it is seen that the effect of financial development on growth shows
similarities with the series handled in the econometric studies, which is the subject of the research. In
this study, in order to examine the relationship between financial development and economic growth,
growth rate of real GDP (gross domestic product) will be studied as an indicator of growth and the rate
of M2 money supply values to GDP, the rate of the credits for private sector to GDP and finally the
rate of total financial assets to GDP will be examined as an indicator of financial development level.
The abbreviations used for the series studied are shown in Table 1. In this context, the analysis
examining the relationship between M2 and OSK series and growth was examined with annual data for
the period 1985-2006. On the other hand, the analysis examining the relationship between TFV and
growth was studied using the annual data covering the period 1995-2006. The data were obtained from
the official websites of the Central Bank of Turkey (CBT) and State Planning Organization (SPO).

Table 1: Data

Real GDP growth rate GR

Rate of M2 to GDP M2
Rate of Credits for private sector to GDP CPS
Rate of total financial assets to GDP TFA

The empirical analysis will be started with the investigation of the steady state of the series.
Steady state of the series is important for the determination of the causality analysis method.
It is seen that generally the ADF test is used to examine the unit root status in time series
analyses. The equations formed and hypothesis used for the ADF test are shown below (Dickey and
Fuller, 1979: 427-431; Dickey and Fuller, 1981: 1057-1072):
The Relationship between Financial Development and Economic Growth: “Econometric Model” 527

H0: Unit root present- I (1)

H1: Unit root absent- I (0)
∆Yt = ρYt −1 + et
(1)
∆Yt = α + ρYt −1 + et
(2)
∆Yt = α + βt + ρYt −1 + et (3)
When the unit root statuses of the series examined in this study are studied, the results obtained
are shown in Table 2.

Table 2: Results of Unit Root Analysis

FOR THE FIRST ANALYSIS PERIOD

Data ADF Test Statistics ADF critical value(%1) ADF critical value (%5)
GR -1.560773 -2.685718 -1.959071
M2 2.974003 -4.498307 -3.658446
CPS 2.567325 -3.857386 -3.040391

FOR THE SECOND ANALYSIS PERIOD

Data ADF Test Statistics ADF critical value (%1) AFD critical value (%5)
GR -3.480350 -5.124875 -3.933364
TFA -1.642221 -5.124875 -3.933364

When the series are examined, it is seen that there is a unit root problem in all series. In this
context, it is necessary to take the first differences of the series to make the series steady. However, in
some cases, taking the first differences of the series may not be enough to make the series steady.
Therefore, the steadiness statuses of the series were re-examined with the unit root analysis after the
first differences of the series were taken. In conclusion, all the series were found to be steady in the
first difference.
After it is understood that all the series are steady in the first difference, the investigation
regarding their causality relationships can be carried out. In this context, the series being steady in the
first difference show that Johansen co-integration analysis can be used to examine the causality
relationships between the series.
Regression equations established with unsteady series cause the problem of false regression to
occur. In this context, taking the difference(s) of the series prevents the problem of false regression.
However, co-integration theory assumes that the regressions to be established with unsteady series can
be steady. In other words, whether linear compositions of unsteady series are steady according to the
co-integration test is tested. When the linear compositions of the series are steady, long term balance
relationships can be investigated between the series. In case the regression series established between
unsteady series are under the effect of the same stochastic trend, the regression will be meaningful. In
case there is a long term balance relationship between the series, the existence of short term
relationships can be searched. Engle and Granger (1987) indicated the imbalances occurring in the
series in the short-run could be eliminated with the error correction mechanism.
It has already been understood that the series are steady in their first difference and Johansen
co-integration test should be used. However, optimum delay length should be investigated before
conducting Johansen co-integration analysis. LR-test results regarding the optimum delay length are
seen in the Annexes. When LT-test results are examined, it is seen that the optimum delay length to be
used for the investigation of the co-integration relationship between GR-M2 series and GR-TFA series
is 1. for searching co-integration relationship between BO-M2 and BO-TFV series. On the other hand,
the optimum delay length to be used in the investigation of the relationship between GR-CPS series is
seen to be 3. After finding optimum delay lengths, the existence of long term relationships between the
series can be examined. Johansen co-integration test results are shown in Table. 3.
528 Rengin AK and Ekrem Kara
Table 3: Johansen Co-integration Analysis Results

Maximal Eigenvalue Test Trace Test

Null (Ho) Alternative Test %5 Null (Ho) Alternative Test %5 critical
hypothesis hypothesis statistics critical hypothesis hypothesis statistics value
value
GR-M2 ζ =0 ζ =1 22.72 15,49 r=0 ζ >0 17.40 14.26
GR- ζ =0 ζ =1 17.91 15.49 r =0 ζ >0 14.81 14.26
CPS
GR- ζ=0 ζ =1 20.90 15.49 r=0 ζ>0 13.90 14.26
TFA

When the results of the cointegration relationship between the series are examined, since the
maximal eigenvalue value test statistic obtained for the model established between GR-M2 series,
which is 22.72, is higher than 5% critical value 15.49, it is concluded that there is at least one
cointegrating vector between the series. When the trace test results are examined, since the test statistic
17.40 is higher than 5% critical value 14.26, it is concluded that there is at least one cointegrating
vector between the series. On the other hand, according to the results of the model formed to search for
the relationship between GR-CPS series, since the maximal eigenvalue statistic 17.91 is higher than
5% critical value 15.49, it is concluded that there is at least one cointegrating vector between the series.
When the results of the trace test are examined, since trace value statistic 14.81 is higher than 5%
critical value 14.26, it is concluded that there is at least one cointegrating vector between the series.
Finally, since the maximal eigenvalue statistic obtained from the model formed to search for the
relationship between GR-TFA series, which is 20.90, is higher than 5% critical value 15.49, according
to the model for searching the relationship between GR-TFA series the statistic value of maximum
essence value 20.90 is bigger than %5 critical value 15.49, it is concluded that there is at least one
cointegrating vector between the series. The trace statistic 13.90 is smaller than 5% critical value
14.26.
In conclusion it seen that there is a long term relationship between GR-M2 and GR-CPS series.
On the other hand, the conclusion showing that there is at least one cointegrating vector as a result of
the maximal eigenvalue test is enough to accept there is a long term relationship between these series.
When the long term relationships between the series are normalized for the GR series, the
following equations are obtained:

GR M2
1.000000 0.026428
(0.00604)

GR OSK
1.000000 0.020799
(0.01828)

GR TFV
1.000000 -0.001968
(0.00068)

When the equations are examined, it is apparent that M2, the rates of credits for the private
sector and finally the increase in the total financial assets value as the indicators of financial
development have a long term positive effect on the real growth rate.
After the long term relationship between the series is clearly seen, it is time to investigate the
short term relationship that may exist between the series.
The error correction mechanism is used to compute how long it will take to eliminate the
imbalances between the series. The results of the error correction mechanism are shown in Table. 4:
The Relationship between Financial Development and Economic Growth: “Econometric Model” 529
Table 4: Error Correction Mechanism

Error D(BO) Error D(BO) Error D(BO)

Correction: correction: Correction:
cointEq1 -1.518347 cointEq1 -1.218612 CointEq1 -0.198495
(0.47901) (0.63310) (0.29854)
[-316979] [-1.92482] [-0.66489]
D(GR(-1)) -0.042126 D(GR(-1)) -0.061976 D(GR(-1)) -0.658363
(0.23810) (0.50660) (0.27364)
[-0.17692] [-0.12234] [-2.40594]
D(M2(-1)) -0.161310 D(M2(-2)) 0.051592 D(LTFV(-1)) -5.115045
(0.060007) (0.43206) (7.43534)
[-2.685545] [ 0.11941] [-0.68794]
C 7.0001417 D(GR(-3)) 0.114953 C 2.866677
(2.85315) (0.27665) (4.73840)
[ 2.45393] [ 0.41552] [ 0.60499]
R-squared 0.651272 D(CPS(-1)) 0.021763 R-squared 0.649212
Adj.R-squared 0.585885 (0.05481) Adj. R-squared 0.473818
[ 0.39709]
D(CPS(-2)) -0.098021
(0.06545)
[-1.49769]
D(CPS(-3)) -0.041988
(0.07398)
[-0.56757]
C 5.118299
(3.56544)
[ 1.43553]
R-squared 0.760173
Adj. R-squared 0.592293

When the results in Table. 4 are considered, the coefficients of the variables of error terms
obtained for the investigation of the short term relationships between the series are negative on the
growth rate series. However, this coefficient should be both negative and statistically significant for a
relationship to exist in the short run. In this context, it is seen that there is a short term relationship
between the growth rate and M2 and the credits for the private sector. However, it has been found out
that there is not a short term relationship between growth rate and total financial assets. When the short
term relationship between growth rate and M2 series is considered, if an imbalance occurs, it will
return to its balance within 0.6 of a period (approx. 8 months). On the other hand, when the
relationship between growth and credits for the private sector is considered, an imbalance that could
occur will go away within 0.8 of a period (approx. 10 months).

Conclusion and Discussion

In conclusion, it is seen as a result of the causality analysis that there is a long term relationship
between the series. In other words, there is a long term relationship between the series examined as an
indicator of financial development and growth rate. This case shows that the increase in financial
development in the long run will have an effect causing an increase in growth rate.
When the short term relationships are taken into consideration, it is seen that M2 and credits for
the private sector have an effect on growth rate. However, there is no evidence regarding the existence
of a relationship between total financial assets and growth in the short run.
530 Rengin AK and Ekrem Kara

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Appendix 1
LR TEST RESULTS FOR GR- M2 CO-INTEGRATION ANALYSIS
Lag LogL LR FPE AIC SC HQ
0 -175.0482 NA 3812225. 20.82921 20.92723 20.83895
1 -124.8569 82.66816* 16758.13* 15.39493* 15.68900* 15.42416*
2 -123.2144 2.318835 22750.09 15.67228 16.16240 15.72100
3 -120.7269 2.926464 29095.65 15.85022 16.53640 15.91843
4 -114.3427 6.008617 25175.82 15.56973 16.45196 15.65743

LR TEST RESULTS FOR GR-CPS CO-INTEGRATION ANALYSIS

Lag LogL LR FPE AIC SC HQ
0 -188.5433 NA 5367937. 21.17148 21.27041 21.18512
1 -144.5859 73.26228* 63722.64 16.73177 17.02856* 16.77269
2 -141.0663 5.083978 68827.95 16.78514 17.27979 16.85335
3 -135.2324 7.130277 59398.82* 16.58138* 17.27389 16.67687*
4 -132.0159 3.216522 72395.68 16.66843 17.55880 16.79120

LR TEST RESULTS FOR GR-TFA CO-INTEGRATION ANALYSIS

Lag LogL LR FPE AIC SC HQ
0 -40.30403 NA 41.55361 9.400896 9.444724 9.306316
1 -27.25978 17.392S33* 5.860706* 7.391063 7.522546 7.107323
2 -26.21542 0.928328 14.23096 8.047870 8.267008 7.574970
3 -16.99231 4.099157 9.575410 6.887181* 7.193974* 6.225121*

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