Nonlinearities between financial development and economic development

Both theory and available evidence accord financial development an important role in economic development. The precise nature of the relationship is as yet less well understood, and recent theoretical work suggests there may be pronounced discontinuities and nonlinearities in this relationship. Most of the available empirical research examining the relationship between financial development and economic development either only tests for linear relationships, uses ad hoc methods to test for nonlinearities, or exogenously specifies the precise nature of the nonlinearity. Further, while theory suggests a host of factors condition how financial development influences economic development, as yet only a few of these factors have been subjected to rigorous empirical test. This dissertation comprises three essays empirically probing the relationship between financial development and economic development. The first essay searches for nonlinearities in the link between financial development and economic growth. Following recent theory, it is hypothesized that the initial level of per capita income and the initial human capital level influence how financial development influences economic growth and that these effects are nonlinear and potentially exhibit pronounced discontinuities, or thresholds. ^ The second essay probes for nonlinearities in the link between financial development and economic growth after controlling for the potential endogenity problem. The third essay considers nonlinearities in the link between inflation and both of the banking finance and equity finance indicators. An innovation of the proposed research is the use of Hansen\u27s (1996, 2000) endogenous threshold methodology and Caner and Hansen (2004) instrumental variable approach to the threshold regression method. Unlike most other methodologies used to explore nonlinearities in the literature, this methodology neither requires that threshold values of mediating variables be exogenously specified nor that the functional form of the nonlinearity be specified. Further, unlike the Durlauf-Johnson Regression Tree approach (Durlauf and Johnson, 1995), Hansen\u27s methodology provides the necessary asymptotic theory to enable tests for the statistical significance of the number of thresholds. The use of these recent econometric techniques will enable a comparison between our results and the traditional cross-country approach and provide better understanding of how the relationship between financial development and economic development changes overtime.