Panel analysis of relationship between financial development and economic growth

Abstract

The aim of this paper is to provide empirical evidence on the relationship between financial development and economic growth and to examine whether there are differences in the size of the impact of financial development on economic growth in countries with different income levels. Furthermore, the impact of additional determinants of economic growth is analyzed. Research problem is lack of empirical evidence on the relationship between financial development and economic growth when financial development is measured by proxy variables on banks and stock markets; low treatment of potential endogeneity problem as well as lack of empirical evidence on the differences in the size of the impact of financial development on economic growth in countries with different income levels. Balanced panel data for 94 countries during the period between 1992 and 2011 are used in this analysis. Five-year averaged data are used to reduce the impact of business cycles and measurement errors. Six models are estimated by using panel fixed and random effects models. However, the analysis indicates that distribution of error terms deviates from normal; the assumption of homoscedasticity is rejected and the presence of endogenous regressor is reported. Therefore, in order to overcome these issues, the dynamic onestep system GMM estimator is used to estimate models. The obtained results indicate that banking sector and stock market development have statistically significant positive impact on economic growth. It has been shown that the impact of banking sector development strongly contributes to economic growth compared to stock market development. Besides, the results show that education has no statistically significant impact on economic growth while inflation, government spending and trade openness have a negative impact. The sixth model indicates that on average financial development strongly impacts economic growth in high and middle-income countries compared to low-income countries, and that the strongest impact is obtained for highincome countries. The results of this paper may motivate policy makers to foster the financial development since it contributes to economic growth. Since financial development contributes to