Financial Development: Economic Growth Nexus in Bangladesh

Abstract

The main objective of this study is to investigate the causal relationship between financial development and economic growth in Bangladesh, particularly the long-run impact of financial development on capital formation and per capita income. A system of equations based on the hypothesis that financial development has long-run impact on investment and per capita income is specified and estimated using Blanchard and Quah's (1989) technique of structural vector autoregressions (SVARs). To examine the short-run dynamics among the variables in the system, however, the impulse response functions (IRFs) and variance decomposition (VDCs) are computed based on Cholesky factorization where the standard errors for VDCs are computed through 1000 Monte Carlo simulations. To substantiate the causal link among the various indicators of financial development, investment and income per capita a graphical presentation has also been used.The graphical presentation as well as estimated coefficients of the long-run response matrix indicates that various indicators of financial development and investment have long-run impact on per capita income. The estimated results also support the argument that in the long-run financial development stimulates investment activities. The estimated coefficients of the long-run response matrix, however, do not provide any statistical evidence whether the lending rate has any impact on financial development, investment or on per capita income. This finding is in line with the conventional view that there is very little or no significant response of economic activities with respect to changes in the interest rate in a developing country like Bangladesh where the degree of monetization is relatively low. As a result, the use of short-term lending rate as a policy instrument would be ineffective in influencing domestic credit or investment and thus per capita income.Regarding the short-run dynamics among the variables in the system, the results from IRFs indicate that both the financial development and investment have short-run impact on per capita income at the immediate year of initial shocks. The results from VDCs, on other hand, imply that all the variables in the system, such as lending rate, indicator of financial development and investment contain very useful information in predicting the future path of per capita income.