The causality between Financial Development and Economic Growth in Ethiopia: Supply Leading vs Demand Following Hypothesis

Abstract

This paper investigates linkage between financial development and economic growth in Ethiopia during the period from 1975 to 2016 using Autoregressive Distributed Lag (ARDL) approach. The paper also schedules Vector Error Correction Model (VECM) in order to observe how fast the cointegrated variables convergence in long-run. Accordingly, the results of bound test confirm existence of the long-run relationship between explanatory variables and economic growth. The empirical results show evidence of long- and short-run positive impacts of financial development on economic growth in Ethiopia which implies that progesses in financial sector contribute to economic growth in both short- and long-run. In consideration of few control variables, the study finds all indicators, except inflation and government expenditure, significantly influence economic growth in the long-run. However, it also reveals that government expenditure, trade openness, human capital, and gross investment are pioneering determinants of the economic growth in Ethiopia in short-run. Moreover, the study employs Granger causality tests in order to show direction of impact is running from financial development to economic growth both in short- and long-run. As a result, it finds that the ‘supply-leading’ hypothesis holds in Ethiopia.