The Dynamic Relationship between Financial Development and Economic Growth: Empirical Evidence from Ethiopia

Abstract

There are different evidences in the literature regarding the relationship between financial development and economic growth. Some studies have found bidirectional causality, others a unidirectional relationship while some found no causality between the two variables. The aim of this study was to see the direction of causality and to investigate the existence of a long run relationship between financial development and economic growth in Ethiopia.  We use two variables namely private sector credit as percentage of GDP and broad money supply as percentage of GDP to indicate financial development and employ Auto Regressive Distributive lag Model( ARDL) to Bounds Testing to examine the long and short-run impact of financial development on Economic growth and Granger Causality Tests has conducted by using Vector error correction Model . The Bound test results suggest that long-run relationships exist between economic growth and both financial development indicators as well as other explanatory variables. Moreover, our findings support both supply leading and demand following hypotheses. The direction of the short-run and long-run causal relationship between economic growth and financial development depends on which financial development indicator is used. Particularly, improvements in financial development indicators related to the resource allocation function of the financial system lead to economic growth whereas economic growth causes financial development through increasing banks’ assets in the long run.