Financial development, economic growth, and business cycle

Abstract

This paper investigates the effect of financial development on economic growth over business cycle in Vietnam. The Markov autoregressive switching model was used to identify the state of expansionary and contractionary economy. Then, the recent developed techniques, ARDL bound test and ARDL within error correction form, were used to examine the cointegration of two variables and the growth effect of financial development over expansions and recessions in the long run. The VEC modelling Granger test was used to check the short run and long run causality of finance – growth nexus. The paper has several interesting findings. First, financial development is cointegrated with economic growth in the long run and it exerts a lager, positive, and statistically significant effect on economic growth in recessions. Second, the VECM Granger test on balance indicates a unidirectional causality running from financial development to economic growth in the long run. Among variables, domestic credit for private sector has a feedback relationship with output growth both in the short run and in the long run. Finally, the choice of financial development indicator not only affects the causality of finance – growth nexus but also influences the growth effect of financial development over expansions and recessions.