Reassessment of the finance-growth nexus in the presence of structural breaks

Abstract

This article investigates empirically the causality between financial development and economic growth for 11 sample countries in a structural break framework via minimum Lagrange multiplier unit-root test and Hsiao's causality test. We find most of the series can be more accurately characterized as a segmented trend stationary process around structural breaks as opposed to a stochastic unit-root process, which has important implications for policy-makers to formulate long-term development strategy and short-run stabilization policies as well as for academics to carry out cointegration analysis. Besides, we find different causality patterns in sample countries, which depart from those found in the existing literature, highlighting that it might be unreliable to apply only conventional unit-root test and inappropriate to take the first difference of the series to achieve stationarity, all of which might result in model misspecification. Our analysis also provides some evidence on the source of the mixed results on finance-growth nexus as they may differ due to the length of data span and the different econometric procedure. ‘One of the most important problems in the field of finance … is the effect that financial structure and development have on economic growth’. Goldsmith (1969, p. 390)