Does Financial Development Promote Economic Growth? A Test of Robustness

The available empirical evidence on the relationship between financial development and economic growth is convincing. Many empirical studies find a strong positive link between financial development and economic growth. There is even evidence that the level of financial development is a good predictor of future economic development. However, cross-section analysis is commonly used to empirically investigate this relationship causing other researchers to question the robustness of these studies. Furthermore, little attention has been paid to the application of modern time-series analysis when testing this relationship. This dissertation will retest the King and Levine (1993a) hypothesis asserting that financial development does matter for economic growth. To extend our understanding of the relationship between financial development and economic growth, new measures are used of the size and activity of financial intermediaries and markets. Also, more robust time-series empirical methods are applied. These econometric techniques include unit root testing, tests of cointegration, panel data testing, and simultaneous-equations time-series estimation. The problems of simultaneity, nonstationarity, and cointegration that accompany time-series analysis are dealt with accordingly. This dissertation first identifies the contributions as well as the shortcomings of previous empirical work. Then, the theory of financial intermediation and why financial development may facilitate economic growth is outlined. The Solow model is presented explaining how financial factors play a leading role in medium-run growth. Finally, a long-run endogenous growth model reveals how financial development fosters the favorable conditions for technological change and permanent economic growth. The 20 countries selected for analysis represent a sample of both developing and developed economies. These countries included seven Latin American countries, four European countries, four African countries, three Asian countries, one Middle Eastern country, and one North American country. The final results from the single, simultaneous, and panel regression equations specified with each of the new financial development variables are fragile. Thus, using the specific econometric methods in this dissertation, there is no consistent evidence confirming a relationship between financial development and economic growth