Credit Market Development and Economic Growth an Empirical Analysis for United Kingdom

Problem statement: This study investigated the causal relationship between credit market development and economic growth for UK for the period 1975-2007 using a Vector Error Correction Model (VECM). Questions were raised whether economic growth spurs credit market development taking into account the negative effect of inflation rate on credit market development. This study aimed to investigate the short-run and the long-run relationship between bank lending, gross domestic product and inflation rate applying the Johansen cointegration analysis. 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 cointegration analysis was applied to examine whether the variables are cointegrated of the same order taking into account the maximum eigenvalues and trace statistics tests. Finally, a vector error correction model was selected to investigate the long-run relationship between economic growth and credit market development. Results: A short-run increase of economic growth per 1% induces an increase of bank lending 0.006%, while an increase of inflation rate per 1% induces a relative decrease of bank lending per 1.05% in UK. The estimated coefficient of error correction term is statistically significant and has a negative sign, which confirms that there is not any problem in the long-run equilibrium between the examined variables. Conclusion: The empirical results indicated that there is a unidirectional causal relationship between economic growth and credit market development with direction from economic growth to credit market development and a bilateral causality between inflation and credit market development for United Kingdom. Bank development is determined by the size of bank lending directed to private sector at times of low inflation rates leading to higher economic growth rates.