The impact of financial development on economic growth in middle-income countries

Abstract

Whether an economy can be categorized as middle-income or not is an empirical issue. We apply the World Bank’s standard to divide middle-income economies into trapped middle-income economies and graduated middle-income economies, and compare them with high-income economies. This paper tests how financial system development positively impacts a nation’s economic development among the above-mentioned three groups of economies. We combine models and methodology from previous studies (King and Levine, 1993a; Levine and Zervos, 1998; Rousseau and Wachtel, 2000, 2002; Xu, 2000). Augmenting these models with new measures and relations of financial development, we find that (1) consistent with previous studies, financial development contributes significantly to economic growth through channels of physical capital stock and total factor productivity; (2) there is Granger causality between equity market development and economic growth for all three groups of economies, although some stronger and some weaker; (3) there is a reverse causality between economic growth and equity market development in high-income economies, which is not detected in other economies; (4) strong evidence of Granger causality and feedback between banking system development and inflation is found only in the trapped middle-income economies.