State Dependence in the Finance-growth Nexus: A Functional Coefficient Approach

Abstract

Noting that one size does not fit all in the case of the finance-growth (FG) nexus, a growing body of literature has recently focused on uncovering economic conditions under which financial development could be beneficial (detrimental) to economic development. We look into these conditions by means of a flexible semiparametric approach which allows the long-run FG nexus to depend on measurable economic states. Using annual data for 74 economies spanning the period 1975-2005, we find that the level of financial development shows a strong positive impact on the FG nexus. Moreover, although the impact of finance on growth is generally higher in high-income economies, allowing for intra-group variations reveals scenarios where the impact could be higher in low-income economies. However, the FG link could also be negative if low- and lower-middle-income economies have very large governments or are extremely open to international trade.