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Table of Contents
Introduction ................................................................................................................................ 2
I. Literature Review ............................................................................................................... 5
II. Economic growth and bond market link ................................................................. 8
III. Specification of econometric model ......................................................................... 9
IV. Data.................................................................................................................................. 11
V. Estimated Results, Documentation and Evaluation ............................................... 12
a) Unit root tests for stationarity ........................................................................................................ 12
b) Estimated model with OLS ............................................................................................................. 13
c) Cointegration test ............................................................................................................................ 14
d) Estimated error correction model by least squares ...................................................................... 14
e) VEC model residuals ........................................................................................................................ 15
Conclusion ................................................................................................................................. 16
Bibliography .............................................................................................................................. 18
Appendix I .................................................................................................................................. 19
Appendix II ................................................................................................................................ 20
Appendix III ............................................................................................................................... 21
Appendix IV ............................................................................................................................... 22
Appendix V ................................................................................................................................. 22
Appendix VI ............................................................................................................................... 23
Appendix VII.............................................................................................................................. 24
Appendix VIII ............................................................................................................................ 25
1
Introduction
This paper estimates an empirical model of the United States economic growth that
links economic activity to the bond market. “Financial development has been view as a key
to economic growth since the classical work of Schumpeter (1911). It promotes or speeds
economic growth through different channels. These include (1) providing information
about possible investments to distribute resources efficiently, (2) monitoring firms and
exerting corporate finance, (3) risk diversification, (4) easing the exchange of goods and
services, (5) mobilizing and pooling savings, and (5) technology transfers.”1
Most of the literature on asset markets and economic growth focus in two
institutions; banks and stock markets, with less attention to the bond market. In brief,
“there are two major reasons: first, bond financing is part of debt financing, which banks
dominates. Second, while in trades, stocks exchange for their equal and their price
discovery process can be analyzed by trading data. Bonds trades over-the-counters, where
transaction data are not transparent nor made publicly available, as equities.”2
Nonetheless, “in many countries (especially in Europe) the total amount of bond
outstanding is greater than that of credit provided by banks, and the size of the government
bond markets trump that of the stock markets. Even more, the bond markets are expected
to experience rapid growth worldwide. For instance, many countries now nurture their
1
Rudra P. Pradhan; Mak B. Arvin; Sara E. Bennett; Mahendhiran Nair; John H. Hall, “Bond Market Development,
Economic Growth and Other Macroeconomic Determinants: Panel Var Evidence,” Asia-Pacific Financial Markets 23,
no. 2 (2016): 176, accessed October 12, 2016, http://link.springer.com/article/10.1007/s10690-016-9214-x.
2
Thumrongvit, Patara; Kim, Yoonbai; Pyun, Chong Soo, “Linking the missing market: The effect of bond markets
on economic growth,” International Review of Economics and Finance27 (2013): 530, accessed October 11,
2016,http://dx.doi.org/10.1016/j.iref.2013.01.008.
2
domestic bond market as a defensive measure against the type of financial crises which
many Asian and Latin American countries faced in the 1990’s. Additionally, growing
numbers of affluent investors in developing countries are pouring their savings into bond
Although not all economist agrees in the degree of importance to financial markets
Additionally, there is evidence that supports the link. Empirically, there are two main
approaches to associate financial development and economic growth. For a start, there is
the production function approach. And second, the granger causality approach, which
examines the direction of causality between financial development and economic growth.4
The aim of this paper is to explore the causal relationship between the economic
growth and bond market. Secondly, measure in which proportion does the bond market
explains the economic growth. And lastly, test how the United States economy fits the
hypothesis in question.
the bond market and the real economic growth: (1) supply-leading; (2) demand-leading; (3)
feedback hypothesis; and (4) no causal relation. For example, the supply leading hypothesis
maintains that accumulation of financial assets triggers economic growth. Inversely, the
3
Thumrongvit, Patara; Kim, Yoonbai; Pyun, Chong Soo, “Linking the missing market: The effect of bond markets
on economic growth,” International Review of Economics and Finance27 (2013): 530, accessed October 11,
2016,http://dx.doi.org/10.1016/j.iref.2013.01.008.
4
Rudra P. Pradhan; Mak B. Arvin; Sara E. Bennett; Mahendhiran Nair; John H. Hall, “Bond Market Development,
Economic Growth and Other Macroeconomic Determinants: Panel Var Evidence,” Asia-Pacific Financial
Markets 23, no. 2 (2016): 176-177, accessed October 12, 2016, http://link.springer.com/article/10.1007/s10690-016-
9214-x.
3
demand-leading hypothesis assumes that real growth drives the emergence and
endogenously determined by the real economy. Alternatively, the feedback hypothesis (or
interdependence hypothesis) implies that the causality goes both ways. Which suggests
that economic growth and financial development can complement and reinforce each
other. And last, it is also possible that development and economic growth are independent
of each other.”56
The structure of this paper goes as follows: Part I, is a literature review of the works
related to the bond market and economic growth relationship; Part II, discusses link,
economic growth-bond market; Part III, the specification of the econometric model; Part
IV, the discussion of the data; and last, Part V, the estimated results and evaluation.
5
Gerhard Fink; Peter Haiss; Sirma Hristoforova “Bond Markets and Economic Growth,” University of Economics
and Business Sdministration Vienna 49 (2003): 6.
6
Rudra P. Pradhan; Mak B. Arvin; Sara E. Bennett; Mahendhiran Nair; John H. Hall, “Bond Market Development,
Economic Growth and Other Macroeconomic Determinants: Panel Var Evidence,” Asia-Pacific Financial
Markets 23, no. 2 (2016): 177, accessed October 12, 2016, http://link.springer.com/article/10.1007/s10690-016-
9214-x.
4
I. Literature Review
“Most of the previous empirical studies which analyze the role of financial markets
on economic growth, have neglected the effect of bond market in the economic growth
process. The perception was that what matters is the state of a country’s financial
development as whole, and anything else was irrelevant as long as and the economy has
system allows persons to cut transaction costs through hedging trading and pooling risk.
Also, it increases the liquidity and size of the capital markets, all which are essential for
economic growth. Specifically, financial markets promote economic growth through two
financial market is divided into two broad sectors; banks and the stock market, as these
Overall, the works relating financial markets to economic growth have different
approaches and focus. And can be complementary with each other in the analysis. For
example, “Pagano (1993), argues that financial intermediation can affect economic growth
by acting on the saving rate, on the fraction of the saving channeled to investment, or on
the social marginal productivity of investment. Further, he notes that there are possible
cases where financial development negatively affect growth. Such as, improvements in risk-
sharing and in the household credit market, since the can decrease the saving rate, hence
7
Thumrongvit, Patara; Kim, Yoonbai; Pyun, Chong Soo, “Linking the missing market: The effect of bond markets
on economic growth,” International Review of Economics and Finance27 (2013): 529-41, accessed October 11,
2016,http://dx.doi.org/10.1016/j.iref.2013.01.008.
5
decrease growth. Also, Pagano theoretical analysis is within the context of the AK growth
model.”8
On the other hand, Harvey (1989), approach the financial markets and economic
growth from another perspective. In his paper, he uses forecasts of economic growth using
the bond market and stock market. Specifically, “his empirical work is based on the modern
asset pricing theories, which suggest a relationship between expected asset returns and
one-year interest rate reflects the marginal value of income today with its marginal value
next year. Hence, if a recession is expected next year, there is an incentive to postpone
present consumption to a buy a one-year bond that pays off in times of recession. As a
result, the demand for the bonds increases bidding its price up and lowering its yield.
Overall, Harvey suggests that the bond market has more information about economic
growth than the bond market. To illustrate, the evidence in his paper suggest that the yield
curve measures are able to explain more that 30 percent of the variation in economic
growth over the 1953-1989 period, while stock market variables explain only about 5
percent.” 9
From another point of view, Hakansson (1998) argues that well-developed corporate
bond market has a positive effect on an economy. For instance, “a well-developed corporate
8
Marco Pagano, “Financial Markets and Growth,” European Economic Review 37 (1993): 621, accessed October 11,
2016,http://www.csef.it/pagano/eer-1993.pdf.
9
Campbell R. Harvey, “Forecasts of Economic Growth from the Bond and Stock Markets,” Financial Analysts
Journal 45, no. 5 (Sep. - Oct., 1989): 38, 39, 44, accessed October 11, 2016,http://www.jstor.org/stable/4479257.
6
functioning market in derivatives. Also, in a well-developed, the lending process is free
from government intervention. Further, the argument suggests that when the relative sizes
of the banking system and the corporate bond market are balanced; and there is a well-
developed corporate bond market, market forces have a greater opportunity to assert
Further, Fink, Haiss, and Hritoforova (2003); “presents evidence on the relationship
between bond markets and real economic growth in the EU15, USA, Japan, Switzerland and
Norway. The estimated models support the supply-leading hypothesis implying that real
economic activity is significantly affected by the development of the bonds market over the
1950 to 2000, time period.” 11Additionally, “Thumarongvit, Kim, Pyun (2013); “shows that
the relationship between corporate bond market development and economic growth
changes from negative, in the study period of 1989 to 2003, to a positive for a study period
from 1989 to 2010. They argue that the expanded bond market together with advance in
Pradahan, Arvin, Bennett, Nair, and Hall (2016); “In their work maintain that bond
market development side-by- side with other key macroeconomic variables may be
10
Nils H. Hakansson, “He Role of a Corporate Bond Market in an Economy – and in Avoiding Crises,” University
of California, Berkeley (1998): 2, 13, accessed October 11,
2016,http://www.haas.berkeley.edu/groups/finance/WP/rpf287.pdf.
11
Gerhard Fink; Peter Haiss; Sirma Hristoforova “Bond Markets and Economic Growth,” University of Economics
and Business Sdministration Vienna 49 (2003): 1.
12
Thumrongvit, Patara; Kim, Yoonbai; Pyun, Chong Soo, “Linking the missing market: The effect of bond markets
on economic growth,” International Review of Economics and Finance27 (2013): 529-41, accessed October 11,
2016,http://dx.doi.org/10.1016/j.iref.2013.01.008.
7
important to economic growth. Bond market development not only reduces the
transaction costs through hedging, trading and burnishing risks, but also increases the
liquidity and the size of the capital markets, all of which are essential for economic growth.
Their Granger causality test confirms that bond market development and four other
macroeconomic covariates may be long-run causes for economic growth. Also, their results
demonstrate that studies on economic growth that do not consider bond market
development, will offer potentially biased results from a policy perspective, since higher
the process, it sets the benchmark interest rates for debt instruments with varying
maturities and risks. Both maturities and risk serve as indicators for the household decision
to save and lend and business decisions to borrow and invest for long-term projects. In
particular, this is important to the link between economic growth and bond market
intermediaries absorb resources. For instance, part of the resources goes to banks as the
13
Rudra P. Pradhan; Mak B. Arvin; Sara E. Bennett; Mahendhiran Nair; John H. Hall, “Bond Market Development,
Economic Growth and Other Macroeconomic Determinants: Panel Var Evidence,” Asia-Pacific Financial Markets 23,
no. 2 (2016): 175-201, accessed October 12, 2016, http://link.springer.com/article/10.1007/s10690-016-9214-x.
14
Thumrongvit, Patara; Kim, Yoonbai; Pyun, Chong Soo, “Linking the missing market: The effect of bond markets
on economic growth,” International Review of Economics and Finance27 (2013): 531, accessed October 11,
2016,http://dx.doi.org/10.1016/j.iref.2013.01.008.
8
spread between lending and borrowing, and to securities brokers and dealers as fees,
commissions etc. In other words, financial intermediaries do not allow the investment and
saving equality. Thus, if bond markets cut this leakage of resources, it also raises the
amount of savings that goes to investment and increases the economy growth rate.15
Particularly, the corporate bond markets reduce the friction and cost of
diversification and allocation of available funds in the economy to the most productive
sectors.16
Specifically, this paper examines the causal relationship between the between the
bond market growth and the real economic growth for the United States economy over the
time period 1969:02-2016:02. The direction of the causality is important for policy
implications. For example, if the bond market growth leads to capital accumulation, policy-
makers might want to encourage the bond market growth. Formally, to find the long-run
equilibrium relationship:17
𝑦𝑡 = 𝛽1 𝑏𝑡 + 𝑒𝑡 (𝟏)
15
Marco Pagano, “Financial Markets and Growth,” European Economic Review 37 (1993): 615, accessed October
11, 2016,http://www.csef.it/pagano/eer-1993.pdf.
16
“Economic Importance of Corporate Bond Market,” International Capital Market Association, March, 2013: 14.
www.icmagroup.org.
17
Gerhard Fink; Peter Haiss; Sirma Hristoforova “Bond Markets and Economic Growth,” University of Economics
and Business Sdministration Vienna 49 (2003): 16.
9
Where:
yt: the real economic growth in period t [Billions of chained (2009) dollars].
bt: the relative change in bond market size in period t [Billions of chained (2009) dollars].
𝒆𝒕 : The residual.
The model implies that when the bond market size increases, the real GDP
increases. However, it is possible that bond market size relative change and real economic
growth are simultaneously determined. Due to, “to explore the relationship between pairs
of time-series variables one must discuss a vector error correction (VEC) or vector
autoregressive (VAR) models. The VEC model applies when there is cointegration between
If one Assumes that yt and bt are “I(1)” in equation (1) and the residuals are stationary.
A straightforward method is to use a two-step least squares procedure. First, use the least
generate the lagged residuals 𝑒̂𝑡−1 = 𝑦𝑡−1 − 𝛽0 − 𝛽1 𝑏𝑡 . Second, use least squares to
18
R Carter Hill, William E. Griffiths, and G C. Lim, Principles of Econometrics, 4th ed. (Hoboken, NJ: Wiley, ©2011), 499.
19
R Carter Hill, William E. Griffiths, and G C. Lim, Principles of Econometrics, 4th ed. (Hoboken, NJ: Wiley, ©2011), 500.
10
For instance, the VEC model allows us to see how much economic growth will
change in response to a change in the explanatory variable (the cointegration part, “𝑦𝑡 =
𝛽0 + 𝛽1 𝑏𝑡 + 𝑒𝑡 "), as well as the speed of the change (the error correction part, “∆𝑦𝑡 = 𝛼10 +
𝑦
𝛼10 𝑒̂𝑡−1 + 𝑣𝑡 " where 𝑒̂𝑡−1 is the cointegrating error. 20
Additionally, the hypothesis test for the estimators will be base on a p-value of 5%.
Consequently, for the results to be statistically significant the p-value must be less than 5%.
IV. Data
Specifically, the source of the data for real economic growth and bond market size
are from Department of Commerce, Bureau of Economic Analysis, and the Federal Reserve
Bank of St. Louis. The analysis range is the period 1969:2-2016:2, quarterly data.
For start, the real economic growth is measured as the relative change in the the real
gross domestic product. the time series is seasonally adjusted at annul rates. Also, it is in
billions of chained (2009) dollars. On the other hand, the bond market size proxy is the
total debt securities for all sectors. The time series is deflated using the GDP implicit price
deflator, with the base period 2009. And lastly, it is use to measure its relative chance (or
20
R Carter Hill, William E. Griffiths, and G C. Lim, Principles of Econometrics, 4th ed. (Hoboken, NJ: Wiley, ©2011), 500.
11
V. Estimated Results, Documentation and Evaluation
“The main reason we prefer stationary time series variables in the regression analysis is
to avoid any significant results from unrelated data. In other words, a spurious regression.
Formally, a time series is stationary if its mean and variance are constant over time, and if
the covariance between two values from the series depends only on the length of time
Specifically, the time series are tested using the ADF and Phillips-Perron test. The
results show that for all the time series in the model, the test statistics are greater than the
5% critical value. Thus, the time series are stationary. (See Unit root tests, Appendix II)
21
R Carter Hill, William E. Griffiths, and G C. Lim, Principles of Econometrics, 4th ed. (Hoboken, NJ: Wiley, ©2011), 482,
477.
12
b) Estimated model with OLS
According to STATA the estimated model using the ordinary least square with Newey-
𝑦̂𝑡 = 1.3844(𝑏𝑡 )
𝑠𝑒(𝛽̂𝑖 ) = (0.1774286)
𝑡= (7.80)
𝑃 > |𝑡| = (0.000)
𝑅 − 𝑠𝑞𝑢𝑎𝑟𝑒 = 0.3547 𝑛 = 189
the results show that the elasticity of bond market capitalization growth with respect to
economic growth is statically significant since the p-value is less than 5% significance level.
Also, the model predicts that each additional 1% growth in the bond market, the US
economy grows by 1.3844%. With regard to the hypothesize, the estimated model agrees
with the fact that economics growth and the bond market capitalization growth have a
positive relationship.
For instance, the model is estimated using the Newey-West standard errors. The
assumption, 𝑐𝑜𝑣(𝑒𝑡 , 𝑒𝑠 ) = 0 (for t different that s). When the assumption is not satisfied,
the OLS no longer is minimum variance, and hypothesis testing unreliable. On the other,
In the regression analysis, the normality in the residual enables us to derive reliable
probability distributions of the estimated parameters and the estimated standard error.
Which simplifies the task of establishing confidence intervals and testing hypotheses.
Specifically, in this paper, we use Bartlett’s formula to test serial correlation and the
skewness/kurtosis to test normality in the residuals. The results show that many of the
13
residuals are serially correlated. However, there is not enough evidence to reject the
normality hypothesis.
(See Estimated model, Cointegration test, Normality test, serial correlation test and
c) Cointegration test
According to the Engle-Granger Test, the residuals derive from the estimated model
are stationary and thus cointegrated. This result implies that economic growth is linked to
In the following section, we estimate the error correction model by least squares to
find out how much is the response of economic growth in a quarter to the bond market
The negative error correction coefficient in the first equation (-0.2300899) indicates
that ∆y falls, when there is a positive cointegrating error. While the positive error
correction coefficient in the second equation indicates that ∆b rises, when there is a
14
positive cointegrating error. This behavior “corrects” the cointegrating error. The error
quarterly adjustment of yt will be about 16.57% of the deviation of yt-1 from its cointegrating
value 1.3844 bt-1. This is a slow rate of adjustment. Also, the error correction coefficient in
the second equation (0.300911) is significant; it suggests that ∆b also reacts to the
cointegrating error. Thus, the result is inconsistent with the supply-leading hypothesis
which maintains that accumulation of financial assets triggers economic growth; and also
deviates from the demand-leading hypothesis which maintains that economic growth
triggers the bond market development. In contrast, the results show evidence of the
feedback hypothesis (or interdependence hypothesis) which implies that the causality goes
both ways. And hence that economic growth and financial development can complement
Further, the VEC model residuals presents evidence of serial correlation according to
the Bartlett’s formula to test of serial correlation. Also, the probability of skewness in both
models is greater than 5%. However, according to the Newey-West standard errors the
coefficients remains significant at a 5% significant level. (See results in Appendix VII and
Appendix VIII)
22
R Carter Hill, William E. Griffiths, and G C. Lim, Principles of Econometrics, 4th ed. (Hoboken, NJ: Wiley, ©2011), 503.
15
Conclusion
channels. These include (1) providing information about possible investments to distribute
resources efficiently, (2) monitoring firms and exerting corporate finance, (3) risk
diversification, (4) easing the exchange of goods and services, (5) mobilizing and pooling
However, most of the literature on asset markets and economic growth focus in
banks and stock markets. Nonetheless, the size of the government bond markets is great
then that of the stock markets. Also, many paper suggest that the bond market is a good
predictor of economic activity while the stock market an unreliable predictor. The degree
the causal relationship between economic growth and the bond market capitalization
growth.
For the purpose of one may consider 4 possible hypotheses in the relationship
between the bond market and the real economic growth: (1) supply-leading; (2) demand-
leading; (3) feedback hypothesis; and (4) no causal relation. According to the results, there
is evidence of the feedback hypothesis. That is, both economic growth and bond market
capitalization relative change are simultaneously determine in the sample period of 1969:2-
2016:2 for the U.S. economy. This results, contrast the other hypothesis of (1) supply-
16
Specifically, the first estimated model implied that the elasticity of bond market
significance level. Also, it predicts that each additional 1% growth in the bond market, the
US economy grows by 1.3844%. The estimated model agrees with the fact that economics
growth and the bond market capitalization growth have a positive relationship. However,
the VEC model shows that in the short-run the rate of adjustment is slow. It indicates that
the quarterly adjustment of yt will be about 16.57% of the deviation of yt-1 from its
cointegrating value 1.3844%. Further, the model suggest that the causality goes both ways.
In sum, the link between economic growth and bond market capitalization is one
which major controversies. For instance, in this analysis, the bond market is studied as a
whole without distinction from government and corporate bonds. It is possible that the
results are much different when such distinction is made. Evermore, the literature is
divided on the directional causality of the three major financial markets; banking, bond
and equity stick that have on economic growth. Which implies that financial development
effect on economic growth is subject to the type financial market in development. With the
purpose to shed light on the problematic, the empirical literature in the subject tries to
combine the endogenous growth theory and the micro structure of financial systems,
17
Bibliography
Fink, Gerhard; Haiss, Peter; Hristoforova, Sirma. “Bond Markets and Economic Growth.” University of
Economics and Business Administration Vienna 49 (2003): 1.
Hakansson, Nils H. “He Role of a Corporate Bond Market in an Economy – and in Avoiding
Crises.” University of California, Berkeley (1998): 1. Accessed October 11,
2016.http://www.haas.berkeley.edu/groups/finance/WP/rpf287.pdf.
Harvey, Campbell R. “Forecasts of Economic Growth from the Bond and Stock Markets.” Financial Analysts
Journal 45, no. 5 (Sep. - Oct., 1989): 38-45. Accessed October 11,
2016.http://www.jstor.org/stable/4479257.
International Capital Market Association. “Economic Importance of Corporate Bond Market.” March, 2013.
www.icmagroup.org.
Pagano, Marco. “Financial Markets and Growth.”European Economic Review 37 (1993): 613-22. Accessed
October 11, 2016.http://www.csef.it/pagano/eer-1993.pdf.
Pradhan, Rudra P.; Arvin, Mak B.; Bennett, Sara E.; Nair, Mahendhiran; Hall, John H.. “Bond Market
Development, Economic Growth and Other Macroeconomic Determinants: Panel Var
Evidence.” Asia-Pacific Financial Markets 23, no. 2 (2016): 175-201. Accessed October 12,
2016.http://link.springer.com/article/10.1007/s10690-016-9214-x.
Thumrongvit, Patara; Kim, Yoonbai; Pyun, Chong Soo. “Linking the missing market: The effect of bond
markets on economic growth.” International Review of Economics and Finance 27 (2013): 529-41.
Accessed October 11, 2016.http://dx.doi.org/10.1016/j.iref.2013.01.008.
Hill, R Carter, William E. Griffiths, and G C. Principles of Econometrics. 4th ed. Hoboken, NJ: Wiley, 2011.
Gujarati, Damodar N., and Dawn C. Porter. Basic Econometrics. 4th ed. The Mcgraw-Hill Series, Economics.
Boston: McGraw-Hill Irwin, ©2004.
18
Appendix I
Real economic growth & Total debt securities for all sectors.
1962:02 to 2016:02
Differences for Real economic growth & Total debt securities for all sectors.
1962:02 to 2016:02
Source: Compiled by author with data from BEA and Federal Reserve Bank of St. Louis.
19
Appendix II
Stationarity test: ADF test
20
Appendix III
Regression Analysis: Real economic growth vs Bond market capitalization relative change
21
Appendix IV
Serial Correlation test
Appendix V
Newey-West standard errors
22
Appendix VI
VEC models
Bond market capitalization relative (difference) change regressed on the error correction
variable
23
Appendix VII
Serial correlation test for Real economic growth (difference) regressed on the error
correction variable
Serial correlation test for Bond market capitalization relative (difference) change
regressed on the error correction variable
24
Appendix VIII
Newey-West standard errors
Bond market capitalization relative (difference) change regressed on the error correction
variable
25