ECN 5114 MACROECONOMICS THEORY

Dr. Normaz Wana Ismail

SEYED HADI HASHEMI GS30992

SHAH BADRI BIN MOHD NOR GS30460
TAN BOON HUI GS31017
TAN CHIA TEE GS30797

Table of Content
Introduction 2
Summary of Core Article 3
Discussion 5
Conclusion 9

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Reference 10

Introduction

The contribution of financial development towards economic growth has received

much attention and is a long debated issue since a few decades ago. Schumpeter
(1911) stated financial development has important effect on growth. This is due to
developed financial structured offer efficient services of financial intermediaries that
transfer of funds to most innovating entrepreneur. According to World Bank, stock
market development is a natural progression in growth process. Recently empirical

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literature on finance and growth mostly focus on cross country growth regression,
time series analysis, panel study, industry and firm level studies and detailed country
case studies.

Financial development refers to the development of well-functioning financial

market and intermediaries. Besides that, financial developments also depend on
financial structure of the economic. There are many financial development indicators
such as M2/GDP, stock market capitalization/ GDP and etc. Furthermore, stock
market can promote economic growth through raising the saving rate, increasing the
level of investment and ensuring past investment are efficiently used. In spite of that,
if we look through theoretical and empirical literature on finance and growth relation,
it showed ambiguous explanation. McKinnon and Shaw (1973) suggested that
government intervention in the financial market impede the process of financial
development and thus economic growth. Their hypothesis has criticized by the neo
Keynesian where they think financial liberalization retard the economic growth as the
liberalization leads crisis rather than stable and efficient function of the system.

In this paper, we will present the summary of core article title: Financial
Development and Economic Growth. After that, we will provide some discussion
raised by other researcher in this topic where some of them support the positive
relation between financial development and economic growth and vice versa. Finally
we include a conclusion of the overall discussion.
Summary of Core Article

In this article, Arestis and Demetriades (1997) examine empirical literature from
2 angles. The first one is investigate to what extent the financial system can contribute
to the process of economic growth. While for the second, they discussed stimulation
of financial liberalization on investment and growth.

The authors demonstrate an analysis of financial development and growth in

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Germany and United States. First, they augment the relationship between economic
growth and financial development by including indicator of stock market
development and volatility. Four variables are employed and three of these variables
are identical for both countries. There are logarithm of real GDP per capita (LY),
stock market capitalization ratio (LMC) and an index of stock market volatility
(LSMV). The fourth variable for Germany is logarithm of the ratio of M2 to nominal
GDP (LM2Y), for United States, it is logarithm of the ratio of domestic bank credit to
nominal GDP (LBC). The authors carried out unit root test, then estimate VAR and
test for cointegration using trace statistic. In the case for Germany, the first vector is
normalized on real GDP per capita and second vector on the banking system
development indicator. In the United States, the first vector is normalized on stock
market capitalization and the second on banking sector indicator. Result indicates that
for Germany, there appears to be uni-directional causality from financial development
to real GDP. However, there is not enough evidence to suggest that in the United
States the financial development causes real GDP. In addition, there is abundant
evidences of reverse causality which show real GDP positively contributing to both
banking system and capital market development.
Arestis and Demetriades (1997) present some new evidences related to the direct
effect of financial repression happen in South Korea. They set VAR length to 2 years
and include the following 5 variables in the analysis: logarithm of the ratio of bank
deposit to nominal GDP (LF), the logarithm of real GDP per capita (LY), the ex-ante
real deposit rate of interest (R), logarithm of capital stock per head (LK) and a
summary measure of financial repression (FR). From the result, the repression index
has a positive effect on financial development, independently of the real interest rate
which has a small positive effect. However, the authors emphasized a word of caution
as the South Korea example will not always be the same.

In a nutshell, the authors have discussed empirical evidence relating to the

relationship between financial development and economic growth. The econometric

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evidence they have applied using time series estimation on individual countries
showed substantial variation across country even though the same variables and
estimation techniques are used.

Discussion

In this section, we would like to investigate the relationship between financial

development and economic growth. There are many kind of methods used to conduct
the test. Most of the researchers used time series analysis which is focus on certain
country. Some studies have further employ panel data to enhance the analysis.

Arestis and Demetriades (1997) has shown different result for Germany and
United State. In the Germany case only unidirectional causality from financial

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development to real GDP. In the United State, there is insufficient evidenve to state
that financial development caused real GDP. On the other hand, there is a lot evidence
to show GDP caused financial development.

Supporting Article

Deb & Mukherjee (2008) had done a research in India Case. The author
mentioned the importance of stock markets development and its causal linkage with
economic growth. The finding from the test showed that there are bi-directional
causality between real GDP growth rate and real market capitalization ratio. Result
showed a unidirectional causality from both stock market activity and vitality to real
GDP growth in India economic. This can be simplified that stock market development
leads to economic growth which is supported by supply leading hypothesis. With the
India stock market assuming more and more importance, this finding could have
significant policy implications for the market regulators and economic planners in
future.

Sanusi and Sallah (2008) have performed their research in Malaysia. The
authors are interested in study of the long run relationship between financial
development and economic growth. They applied time series method to estimate their
model. Three variables are included to represent the financial development indicators,
namely, the broad money, credit provided by the banking system and deposit money
bank. The authors found out theoretically financial sectors play a crucial role that
responsible in economic growth. They said that the Keynesians and Monetarist
schools of thought believed the financial indicators will affect real sectors and
development in the financial market will increase the financial aggregate. This view
of Keynesian and Monetarist have been strengthen by empirical works which done by
King & Levine (1993). The test result suggested broad money (M2) and credit
provided by the banking system (CR) has positive long run impact on economic
growth. Whereas for domestic bank relative to the central bank in allocating domestic

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credit (DP), has a negative long run impact on economic growth. This implied that the
central bank which is greater than the domestic bank in allocating deposit credit. It
can conclude the financial development can affect economic growth which is
consistent with Deb & Mukherjee (2008) findings.

Rufael (2009) test for the financial development and economic growth in
Kenya. The proxies are money supply, liquid liabilities, domestic bank credit to the
private sector and total domestic credit provided by the banking sector. The 3 out of 4
proxies found bi-directional causality runing between financial development and
economic growth except for the broad money or money supply. The author finding
agree with financial development promotes economic growth. Moreover, the policies
aimed to enchance the development of the financial sector can contribute growth.

Adnan Hye & Dolgopolova (2011) present their research in China. They
employed principal component method (PCM) to evaluate the importance of each
financial indicator development index. Then, they use four variable namely the
financial development index (F), real interest rate (R), capital (K) and labour (L) as
determinant of economic growth. Real GDP is used as a proxy for economic growth.
By using JJ cointegration technique, the authors are able to conclude positive
relationship exist between economic growth, financial development index, real
interest rate, capital labor force. The result supports the financial development index
has positive impact on economic growth.

Acaravci, Ozturk and Acaravci (2007) had done the research in the Turkey.
The result is little but different from the previous article.The author use the domestic
credit provided by banking sector as the financial development indicator. After
checking the cointegration test, the result does not support long run relationship
between financial development and economic growth. After that, the author continue
the test with the short run test between these two variable . The result showed only
unidirectional relationship which is financial development caused economic growth in
the short run. Finally the author conclude that the financial development which will

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lead to economic growth and it also support the supply leading hypothesis. The
healthy of the domestic banking sector and domestic credit provided in banking sector
has being assumed will contribute to the economic growth in the Turkey case.

Apergis, Filippidis, and Economidou (2007) are one of the researcher estimate
using panel data analysis. The proxies of the financial development are liquid
liabilities, bank credit, and a set of the control variable. The set of control variable
such as Average Year of Schooling, Output Share of Investment, Government
Spending, Volume of Trade as share of GDP and the error term. Overall result
supported the financial development statistically significant to the economic growth.
Besides, the author also gets the result which is support bidirectional between
financial development and economic growth. They mentioned that the policies aiming
at improving financial markets and their functions will have, in the long run, a
significant effect on economic growth. Such policies are especially important for the
group of developing countries where the impact of financial sector development on
growth is found to be stronger compared to that in industrial countries, in other word
to say is reforms in the financial sector that could contribute further to economic
growth. The policies that can foster macroeconomic stability, such as increased
openness, investment in physical and human capital and productive government
spending, which will improve economic growth, would also have an important effect
on financial development in the long run.

Non Supporting Article

Adnan Hye (2011) finding on India is contradict with above finding. This
study construct financial development index (FDI) from India by using four ratio that
are widely used in empirical literature as an indicator of financial development. The
author use time series method to test either the financial development bring crises or
growth. The author get the negative result which showed that financial development
negatively associated with economic growth. Labour and capital according to growth
theory positively determine economic growth in the long run. However, real interest

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rate statistically insignificant associated to economic growth in short run.

Kar, Nazlioglu, & Agir (2011) have obtained different result compare to the
previous panel data. The proxies variable for financial development also quite
different. Such as the ratio of narrow money to income, (ii) QM/Y: the ratio of quasi
money to income, (iii) M2/Y: the ratio of M2 to income, (iv) BDL/Y: the ratio of
deposit money bank liabilities to income, (v) CPS/Y: the ratio of private sector credit
to income, and (vi) DC/Y: the ratio of domestic credit to income. Real income (RY) is
chosen as a proxy for the economic growth. The author used SURE estimator and
their result does not provide strong evidence supporting the view of financial
development is an important determinant of the economic growth in MENA countries.
One of the main reasons is due to strict control of the financial sector for a long time
in these economies will lead to delay in financial reform which can resolve the
persistence issues. The high transaction cost and information cost will hinder
development in the financial sector. Furthermore, the government intervention in
credit allocation and financing losses of public sector enterprise are main
characteristic of the financial system. The author concluded their finding support
demand follows and supply lending hypothesis. The author also mentions that focused
solely on development of the financial sector may not result in economic
development, where the financial sector follows economic growth in MENA
countries. Lastly, financial sector should provide sufficient resources by creating new
instruments, institution, and organization for the demand of real sector with the
progress of economic development where the economic growth leads development of
the financial sector

Conclusion

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There is a lot empirical evidence have showed financial development is correlated
with and perhaps improve economic growth. From discussion above, we can see that
panel data is indeed a good method to analyze the appropriate relationship. Most of
the researcher use real GDP as a proxy for represent economic growth, and couple
with other financial ratio selected cautiously to match with their research objective.
Although there are a number of papers in financial development and economic
growth, there is still a vast area of financial system which seems to be a promising
avenue for future research.

Reference
Acaravci, A., Ozturk. I., & Acaravci, S.K. (2007). Finance-Growth Nexus :Evidence
from turkey. International Research Journal of Financial and Economic, 30-
39.

Adnan Hye, Q. (2011). Financial development index and economic growth: empirical
evidence from India. The Jounral of Risk Finance, 98-111.

Adnan Hye, Q. M., & Dolgopolova, I. (2011). Economics, finance and development
in China Johansen-Juselius co-integration approach. Economic, and
development in China, 311-324.

Adnan Hye, Q., & Dolgopolova, I. (2011). Economics,finance and development in

China. Chinese Management Studies, 311-324.

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Apergis,N., Filippidis,I., & Economidou, C. (2007). Financial Deepening and
Economic Growth Linkages: A Panel Data Analysis. Review of World
Economics, 179-198.

Arestis, L., and Demetriades, P. (2011). Financial Development and Economic

Growth:Assessing the Evidence. The Economic Journal, 783-799.

Deb,S.G., & Mukherjee J. (2008). Does Stock Market Development Cause Economic
Growth? A Time Series Analysis for Indian Economy . International Research
Journal of Finance and Economics, 1450-2887.

Kar, M., Nazlioglu, S., & Agir, H. (2011). Financial Development and economic
growth nexus in the MENA countries:Bootstrap panel granger causality
analysis. Economic Modelling, 685-693.

King, Robert.G. & Rose Levine, 1993a. Financial and Growth: Schumpeter Might Be
Right. The Quarterly Journal of Economics 108, 717-727.

King, Robert.G. & Rose Levine, 1993b. Finance, entrepreneurship, and growth.
Journal
of Monetary Economics 32, 513-542

Rufael, Y. (2009). Re-examining the financial development and economic growth

nexus in Kenya. Economic Modelling, 1140-1146.

Sanusi, N. A & Sallah, N. H. M. (2008). Financial development and economic growth

in Malaysia: An application of ARDL approach. journal of economic
cooperation, 61-82.

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