Causality between Financial Development and Economic Growth: Empirical Evidence from Ethiopia: (Johansen and VECM Approaches)

Abstract

The nature of the relationship between financial development and economic growth has been one of the most debated issues in the recent past, yet with little consensus. Thus, the general objective of this study was to analyze the existence of long run co integration and direction of the causality between financial development and economic growth in Ethiopia from 1973-2008. The sources of the data were World Bank database and National Bank of Ethiopia. To analyze the data the researcher used Johansen and Vector Error Correction (VEC) modeling approaches with the help of E-views software version 9. The Johansen co-integration testing methodology proved existence of the long run con-integration among variables. The Outcome from vector error correction (VEC) model revealed that in the long run Private credit by deposit money bank and other financial institutions to the GDP ratio and real GDP growth rate have bi-directional causality and Deposit Money Bank assets to the GDP ratio and real GDP growth rate have unidirectional causality which runs from finance to Economic growth. However, in the short run there is no causality between financial Development and economic growth indicators. Therefore, it is recommendable for the government to create conducive condition for the development of finance to sustain its contribution for economic growth.

Keywords: Financial Development, Economic Growth, Johansen and VECM