A Causal Relationship between Financial Market Development and Economic Growth

Problem statement: This study investigated the causal relationship between financial market development and economic growth for United Kingdom for the period 1965-2007 using a Vector Error Correction Model (VECM). Questions were raised whether financial market development causes economic growth or reversely taking into account the negative effect of interest rate. The objective of this study was to examine the causal relationships between these variables using Granger causality tests based on a Vector Error Correction Model (VECM). Approach: To achieve this objective classical and panel unit root tests were carried out for all time series data in their levels and their first differences. Johansen co-integration analysis was applied to examine whether the variables are co-integrated of the same order taking into account the maximum eigenvalues and trace statistics tests. A vector error correction model was selected to investigate the long-run relationship between financial market development and economic growth. Finally, Granger causality test was applied in order to find the direction of causality between the examined variables of the estimated model. Results: A short-run increase economic growth of per 1% leaded to an increase of stock market index per 0.6% in United Kingdom, while an increase of interest rate per 1% leaded to a decrease of stock market index per 1.59% in United Kingdom. The estimated coefficient of error correction term found statistically significant with a negative sign, which confirmed that there was not any problem in the long-run equilibrium between the examined variables. The results of Granger causality tests indicated that there is a bilateral causal relationship between economic growth and financial market development. Conclusion: Therefore, it can be inferred that economic growth has a positive effect on financial market development, while interest rate has a negative effect on it in United Kingdom.