GDP AND FINANCIAL DEVELOPMENT TO CHECK FOR THE DIRECTION OF CAUSALITY

GDP AND FINANCIAL DEVELOPMENT TO CHECK FOR THE DIRECTION OF CAUSALITY

The proposed research will investigate GDP and financial development to check for the direction of causality. The period will be from 1963-2013.

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CHAPTER ONE

INTRODUCTION

1.1 BACKGROUND TO THE STUDY

Literature is plentiful that affirms the significant role of financial development in economic growth. Researcher generally agrees that the financial sector promotes economic growth through two ways: (1) improvement of total factor productivity and (2) inducing saving by increasing the rate of return on savings for instance (Levine 1997) argues that financial intermediaries by facilitating risk management, identifying financially viable project monitoring management and facilitating the exchange of goods and services can promote efficient capital allocation which leads to improvement in the total factor productivity (greenwood & Jovanovic, 1990) show that financial intermediation provides a vehicle for diversifying and sharing risks which can be achieved by inducing a capital allocation shift towards risky ” high expected risks” projects. This shift then spurs improved productivity and economic growth.

Empirical evaluation of the relationship between financial development and economic growth has taken three main strands. The first group of scholars argue that financial development lead to economic growth (supply leading response) example are (Goldsmith, 1969), (King & living, 1993) (McKinnon, 1973) among others. The second group of scholars such as (Gurley & shaw, 1967) and (Jung 1986) maintains that it is economic growth which leads to the development of financial development sector (demand following a response) whereas the third group contends that both financial development and economic growth Granger cause one another (bidirectional causal relationship) (greenwood & Jovanovic, 1990) (luintel & khan, 1999).

The argument of (Patrick, 1966) which have been famously coined as the “Patrick hypothesis” reasons that the direction of causality between economic growth changes over a country course of development. In Patrick’s view financial development is able to induce real innovation for investment before sustained modern economic growth gets underway and as modern economic growth occurs, the supply leading impulse gradually becomes less and less important as the demand-following financial response becomes dominant.

In Africa, there is also no consensus regarding the directional of causality. For example (Ghirmay, 2004) find that financial development played a causal role in the economic growth in Nigeria. African countries he investigated (Agbestziafa, 2003) find mostly unidirectional causality running from financial development to economic growth in seven African countries thus leading support for the supply leading phenomena of the finance-growth nexus.

In the case of Egypt, Morocco and Tunisia different authors using four different indicators of financial development, find a bidirectional causality running between financial development and economic growth in contrast (Baliamoune-lutz, 2008) find a mixed result for north African countries. Similarly using three indicators of financial development a weak causal relationship is found in almost all the twelve west African countries that were studied (Odhiambo, 2004) the author also find a conflicting result for three African countries where the demand following was supported in Kenya and South Africa while in Tanzania the supply leading response was supported.

The aim of the study was to test Patrick’s hypothesis in Nigeria. The empirically investigated the long-run causality between financial development and economic output for Nigeria for the period 1963-2013. Dynamic panel analysis will be used to evaluate the relationship whereas a multivariate time series model to get the direction of causality.

1.2 PROBLEM STATEMENT

Research on the relationship between financial development (FD) and economic growth has yielded mixed results. Whereas researchers agree on the presence of a positive relationship between finance and growth they rarely agree on the directional of causality and the path the relationship the idea that the relationship between finance and growth could vary over-development phases of a country in particular, at the initial stage of economic development, financial development will lead to economic growth however as real growth takes place in the economy this link becomes of lesser importance and growth will induce the demand for greater financial service.

Causal review of the growth and development indicator in Nigeria reveals that data does not follow Patrick’s hypothesis. Per capita growth rate remained relatively constant over the years even with varying levels of financial development as measured by the ratio M2/GDP. As such one would conclude that over time finance and growth in Nigeria have not moved in synchrony as expected. It is therefore evident that there is some point of disconnect in the finance growth transmission channel in Nigeria despite the apparent disconnect, a researcher has devoted their effort carrying out single country analysis and rarely do they study the direction causality taking into account the differences in economic development in Nigeria. The study aims to address the issue using dynamic panel analysis to account for the varying degrees of development and employed pairwise Dumitrescu Hurley panel causality test methodology to test multivariate causality between financial development and economic growth in Nigeria for the period 1960-2013.

1.3 PURPOSE OF THE STUDY

Scholars and policymakers are interested in knowing whether FD could lead to economic growth which in turn helps the development in the country and reduce poverty.

The debate on the direction of the causality between financial development and economic growth has been ongoing since the 19th century. There are two major theories that explain the causal relationship between FD and economic growth. The demand following theory (Robinson 1952) and the supply leading theory (Schumpter 1934 and Patrick 1966). The first suggestion that FD will follow economic growth because when the economy grows it generate new demand for financial service and thus the financial development promotes economic growth and thus financial development has positive effects on economic growth.

1.4 RESEARCH QUESTION

1. Does the relationship between development and economic growth vary with the level of development in Nigeria?
2. What is the direction of causality between FD and economic growth?

1.5     RESEARCH OBJECTIVE HYPOTHESIS

1. To model the varying relationship between financial development and economic growth in Nigeria.
2. To identity the direction of causality between financial development and economic growth in Nigeria.

1.6 SCOPE OF THE STUDY

The proposed research will investigate GDP and financial development to check for the direction of causality. The period will be from 1963-2013. This is to cover most of the stages in Patrick hypothesis, this study used Nigeria as a case study, the criteria used to choose was the availability of data in this country, a data source is the world development indicator of the world bank.

1.7 SIGNIFICANCE OF THE STUDY

The linkage between financial intermediation and economic growth remained theoretically and empirically controversial providing evidence on this causal influence is crucial not only for economist but also for policymakers which are permanently looking for optimal reform decision tending to promote financial intermediaries development (Ghazi & Mohammed 2004) a lot of research has been done on the finance growth nexus but for specific countries the method used for example VAR many did not put into consideration the used of cross-sectional data which will lead to the user of dynamic panel analysis.

1.8 DEFINITION OF TERMS

FINANCIAL DEVELOPMENT: it is the process that marks an improvement in quantity, quality and efficiency of financial intermediary service which revolve around both GDP and the use of money e.g the MP2 this process involve the interaction of money activities and institutions and possibly associated with economic growth it is a part of private sector development strategy to stimulate economic growth and reduce poverty.

ECONOMIC GROWTH: it is the increase in the inflation-adjusted market value of the goods and services produced by an economy over time it is conventionally measured as the percent rate of increase in real gross domestic product it can be seen as an increase in the production of economic goods and services compared from one period of time to another it can be measured in nominal or real (adjusted for inflation) terms.

DYNAMIC PANEL ANALYSIS: it means that the present value of selected the variable strongly depends on its own lagged value.

The dynamic panel model contains a dependent variable with one or more lagged according to its characteristics.

SUPPLY LEADING HYPOTHESIS: it means that financial development is the driver of economic growth.

DEMAND FOLLOWING THEORY: it means that financial development is simply a response to the greater demand for financial service as the real economy grows. It postulates that economic growth leads to financial development.

COINTEGRATION: it is a test that analyzes non-stationary time series processes that have variances and means that vary over time. In other words, the method allows you to estimate the long-run parameters or equilibrium in the system with the unit root variable.

1.9     LIMITATIONS OF THE STUDY

There are two limitations to this approach first, using a statistical test series of a single hypothesis is not equivalent to testing those hypotheses jointly. The result of using a separate test could be unreliable to circumvent the limitation, in this paper we suggest employing the multivariate linear Granger test. To examine the linear causal relationship between financial development and economic growth.

The second problem is that a traditional linear Granger casualties test may fail to detect the non-linear causal relationship between financial development and economic growth.

The debate on the direction of causality between financial development and economic growth has ignored the non-linear behavior which could be caused by structural break.

1.10 ORGANIZATION OF THE STUDY

However, despite using both multivariate linear and non-linear causality to study the causality relationship between FD and economic growth, one may not believe that there is no relationship between FD and economic growth in any country. To solve this problem we recommend scholars and practitioners use both cointegration and multivariate linear and nonlinear causality to study the causality relationship between financial development and economic growth.