Theoretical Models and Empirical Evidence - Research Paper Example

Macro & Micro economics Table of Contents Introduction 3 Construction of the Analysis 3 Theoretical Models and Empirical Evidence 4 Factors determining financial growth 6 Data Source 8 Methodology 8 Limitations of the model: 9 Empirical Results 10 Reference List 13 Appendix 14 15 Introduction There has been an intensive research to determine how financial development and economic growth are related. There is a continuous debate about this relationship and researchers have also tried to find the direction of causality between the both. There are various indicators of financial development. Literature has considered different variables as proxies for financial development. There is a significant divergence in opinion among the economists and policymakers and they fail to reach a unique conclusion (De Gregorio and Guidotti, 1995). Financial development is indirectly related to many macro variables and it is not easy to determine specific proxies for the same. The literature in general suggests various attribute which influence financial development. Information about productive investment activities can have an impact on financial development of a country. Also, enhancement of information related to capital distribution within various sectors of economy is reflected though development in financial conditions. Financial markets heavily rely on publicly and privately available information. The performance growth of companies also influences financial development. Globalisation also helps in integrating business operations within nations. This leads to diversification in services. Risk is managed efficiently. All the above can indirectly lead to development of financial situation in a country. Liberalisation has also made accessibility of resources easier (Demetriades and Hussein, 1996). Construction of the Analysis This paper is structured in six parts. The first section studies about the vast theoretical and empirical evidence analyzing the relationship between financial development and growth in economical conditions in a particular country or over multiple countries or regions. There have been ample discussions about the issue and theories have been developed over time. Economists and researchers have come up with contrasting methodologies, empirical methods and conclusions to establish a relation between the variables. The next section discusses about the various factors that would help to set up a model for the purpose of analysis. The variables are studied to see their effectiveness and appropriateness in determining economic growth which is the dependent variable in this study. Data source and the time period considered for analysis is also mentioned in the following section. The next section discusses the methodology that would be followed for estimating the relationship between the endogenous and exogenous variables. The limitations of the model that has been used for the analysis is also discussed. The interpretations of the results are illustrated in details to understand the significance of the relationship between economic growth and financial development. Finally, the results are analysed with respect to theoretical literature (Jung, 1986). Theoretical Models and Empirical Evidence There is sufficient theoretical evidence that supports a direct relation between economic growth and financial growth. Financial instruments like tradable assets, market indicators and institutions have come up to improve the outcomes arising from information generation and costs due to economic exchange namely transaction cost. Lower transaction cost enhances economic growth (Khan, 2001). Savings rate in an economy is influenced when there is reduction in transaction cost. Decisions related to investment in the process get affected due to its causal relation with savings. Positive investment decisions also encourage innovations in technology which is essential for growth in output. There are several theoretical models which emphasizes on steady state growth rates. Solow model shows the relation between output, investment and consumption which is directly influenced by capital and labour in an economy. It has been seen that investment is a crucial factor that helps in the economic growth. Financial operations are also affected indirectly by economic activities. There is a bi-directional relationship that leads to dynamic inferences about economic growth (Klein and Olivei, 2008). There has been a continuous debate among the economists about the prevailing relationship between economic growth and development in financial condition. Some economists like Shaw (1973), Walter Bagehot (1873), Goldsmith (1969), John Hicks (1969), King and Levine (1993), McKinnon (1973), Merton Miller (1988) and Joseph Schumpeter (1912) identified that financial development is essential for growth in an economic sector of a country. Joan Robinson (1952) proposed that financial development is essential for the growth of enterprises in an economy. Growth of enterprises and industries are crucial for economic growth. However, according to Robert Lucas (1988), economists often over emphasize the role of financial development to enhance economic growth. He stressed on the fact that other than development in the financial sector, there are other sectors which directly influence financial development. Robert proposes that output in an economy is enhanced through production. Financial development is not the primary factor that determines economic growth. Robinson (1952) also shared the same view (Levine, 1997). Financial growth and economical growth has been studied intensively in the literature. Regression analysing growth statistics over various countries has been analyzed to understand the factors determining growth in the era of globalization. Analysis over a time period has given different results for different phase of business cycle. The results have varied with recession and boom. Time analysis has demonstrated changes over the business cycles. Economists have also taken help of a panel structure to study the relationship between financial and economic growth where cross country analysis has been run over a time period. There are also instances where economists have used firm and industry level attributes instead of country level data to analyze the prevailing relationship. Empirical studies have also revealed that efficient financial operations help to ease financial control that exists internally and hinders industrial growth. It has been seen that countries which has a developed market and an improved banking sector helps in economic growth (Levine, Loayza, and Beck, 2000). Factors determining financial growth Financial growth is affected by various determinants. The factors affecting financial growth also differ with the region. There are several determinants which are specific to a particular country. Business cycle in a country also influences the financial growth in a country. So factors related to business cycles are important determinants of financial growth. Recessionary pressures may identify certain factors which becomes prominent and useful during a period of crisis. There are certain factors which become more meaningful during a boom. Selection of factors should be done with respect to all such economic conditions in a country or region. The integration of financial activities all over the world also makes it imperative to consider global factors. The inclusion of country specific factors cannot be sufficient for the analysis. Globalization of financial activities requires that variables that affect the global variables are taken into consideration for the analysis (Patrick, 1966). Before identifying the factors, it is necessary to consider a country or region for the purpose of analysis. The United States is selected as an area of interest for this study. The volatile economic growth of the country gives ample scope for empirical research. The financial sector in the United States plays a major role in influencing economic growth of the country and it becomes imperative to identify the relation between economic growth and financial growth of the country. On studying the business cycles of the United States, it can be seen that most of the recessions in the country were mainly due to financial crisis. The crash of the financial system has always influenced economic growth negatively in the United States. Booming economic conditions are also contingent to financial development. There is a need for empirical support to prove the causal relation between both economic and financial growth to enhance the overall growth of the nation (Pagano, 1993). Economic Growth in the United States can be measured by the Gross Domestic Product (GDP). So the dependent variable or the output variable in the analysis is the US GDP. Financial growth can be measured by several domestic and global variables. For modeling purpose, the independent variables that act as proxy for financial stimulators can be categorized into various broad factors. Financial development is dependent on the activities of the money market in the United States. The Treasury bill and commercial paper are used to reflect the activities in the money market. Short term yield for both the factors are used in the analysis. Specifically, a three month yield is used. The equity market movement in the United States is a vital factor that influences financial growth in the country. The S&P 500 Index is used in the analysis to understand the stock price changes. Stock market is always an important factor that acts as a driving force for financial growth in the country. The stock return of the same index is used in the analysis to capture the future growth trends of the country. The bond market is equally important for understanding financial growth of the nation. The bond market in United States is largely influenced by the bond markets in the emerging markets. Emerging markets like India and Hong Kong are used for that purpose. The government bond spread of the United States with these countries is used in the analysis. The general financial activities of the United States are used by Bloomberg to construct an index to reflect the financial health of the country. That index is used in the analysis. The Federal Reserve of the United States plays a vital role in stabilizing the financial activities in the country. It undertakes various management policies through the modifications in money supply. Thus money supply is an important determinant of financial growth and is included in the analysis (Wurgler, 2000). Financial activities in a country are often influenced by the prevailing exchange rate. The exchange rate in turn is highly influenced by international trade. The spot return of current yield of the United States with India and China is used in the analysis. Data Source The focal objective in this study is to see how financial growth and economic growth are related to each other. This study primarily attempts to identify a relationship between economic and financial activities in the country to understand the trend in both the sectors. Financial development is a broad concept and so different variables are identified to act as proxies for financial growth. Data for the various determinants are collected from various sources. The analysis is done on monthly data ranging from the period July 2005 to May 2014. The Monthly Real GDP Index data is taken from Macroeconomic advisors which is a research firm in the United States. They provide data that helps to evaluate economic health of the United States. The economists and researchers have used several determinants as explanatory variables. This study also uses alternative several explanatory variables for the modelling purpose. The data to capture the proxies for financial growth are collected from various sources such as Bloomberg and Federal Reserve database. Methodology This study uses the method of Multiple Linear Regression model for establishing a relation between economic growth and financial development. Multiple Linear Regression model is a process that helps in the estimation of a linear equation with associated coefficients and helps to find the associated coefficients. The inclusion of more than one variable in the framework makes it a multiple regression model. The model helps to identify a quantitative outcome for the dependent variable with the help of the explanatory variables. The purpose of the study is to see how economic growth, which is the Y (dependent) variable in this analysis, depends on proxies for financial development or simply the independent variables (X1, X2,............ , Xk). The analysis in this study is organized as given in the following equation: Y = A + B1X1 + B2X2+ B3X3 +……………………………………...+B10X10+ U where A is the intercept coefficient, B’s are the slope coefficient and U is the error term. The dependent variable (Y) is normally distributed in a multiple regression model. Limitations of the model: Multiple Regression Models generally provides robust results and appropriately helps to establish a relationship between the dependent variable and the explanatory variables. However, this type of modelling suffers from many problems. The model only incorporates and identifies linear trend present in the data. Polynomial trends are completely ignored. The model may also lead to the presence of outliers in some cases. The model fails to determine the direction of causal relation between the dependent and independent variable. It may happen in some cases that a dependent variable may get affected by the independent variables and the dependent variable may also affect the independent variables. There can be a bi directional relationship between both. But the model cannot identify such causal relationships. The model also fails to provide any specification about the lag at which the variable becomes significant. Identification of the significant lag is essential for the understanding of the business cycles in a model (Calderón and Liu, 2003). Empirical Results After running the Multiple Regression Model with the dependent and independent variables, we get the following results: Regression Statistics Multiple R 0.984293 R Square 0.968833 Adjusted R Square 0.965587 The R square value in the regression analysis shows the effectiveness of the fit to explain variation in the data. Generally, R-square values lie between Zero and one. A value close to one explains very good fit of the data. In this study, the R-square value is very high and it almost near to one which justifies the model construction. The adjusted R-square takes into account the residual degrees of freedom and gives a better interpretation of the model. The adjusted R-square statistic takes on any value less than or equal to 1. A value closer to one indicates a better fit. The adjusted R-square statistic also indicates a good fit in our study. The F statistic is also high and it is significant at 1% level. The intercept coefficient is significant at 1% level. The regression shows that the United States Currency spread with China negatively effects economic growth in the United States at 5% level. The bond spread yield of the United States with India and Hong Kong also negatively affects economic growth of the United States at 5% and 10% level respectively. The S&P Index positively affects economic growth in the United States. The variable is significant at 1% level. The index return also positively affects the GDP at 10% level. Finally, Money Supply (M2) is also highly significant at 1% and positively affects economic growth. However, the currency spread of the United States with India, Treasury bill and commercial paper rates fail to explain economic growth. Figure 1: Relationship between actual and predicted Y (Source: Author’s creation) The figure shows a relationship between the predicted growth and actual growth. Both the blue line and red line move in the same direction and at the same level. This indicates that the explanatory variables appropriately explain economic growth in the United States. The model also gives a good fit. Thus the model can identify a relationship between economic and financial growth (Christopoulos and Tsionas, 2004). The results of the analysis can be interpreted with respect to the theoretical literature. Literature has always stressed on the role of stock market for enhancing economic growth in a country (Arestis, Demetriades and Luintel, 2001). Both stock index and its return suggest the theoretical literature in our study. The role of currency and exchange rate is also discussed in the literature. Exchange rate has a major role to play in a country’s economic growth (Beck, Levine and Loayza, 2000). The results of our study predict the same. Finally, money supply is an important proxy for financial development (Benhabib and Spiegel, 2000). This is because all the Federal Reserve policies are accounted through the changes in money supply. Money supply directly affects all the activities of the banking sector. Interest rate changes are accounted for in the process. The whole process influences financial activities of a nation. The study thus establishes a relation between economic growth and financial growth by putting light on the theoretical background. Reference List Arestis, P., Demetriades, P. O. and Luintel, K. B., 2001. Financial development and economic growth: the role of stock markets. Journal of Money, Credit and Banking, pp. 16-41. Beck, T., Levine, R. and Loayza, N., 2000. Finance and the Sources of Growth.Journal of financial economics, 58(1), pp. 261-300. Benhabib, J. and Spiegel, M. M., 2000. The role of financial development in growth and investment. Journal of economic growth, 5(4), pp. 341-360. Calderón, C. and Liu, L., 2003. The direction of causality between financial development and economic growth. Journal of Development Economics, 72(1), pp. 321-334. Christopoulos, D. K. and Tsionas, E. G., 2004. Financial development and economic growth: evidence from panel unit root and cointegration tests. Journal of development Economics, 73(1), pp. 55-74. De Gregorio, J. and Guidotti, P. E., 1995. Financial development and economic growth. World development, 23(3), pp. 433-448. Demetriades, P. O. and Hussein, K. A., 1996. Does financial development cause economic growth? Time-series evidence from 16 countries. Journal of development Economics, 51(2), pp. 387-411. Jung, W. S., 1986. Financial development and economic growth: international evidence. Economic Development and cultural change, pp. 333-346. Khan, A., 2001. Financial development and economic growth. Macroeconomic Dynamics, 5(03), pp. 413-433. Klein, M. W. and Olivei, G. P., 2008. Capital account liberalization, financial depth, and economic growth. Journal of International Money and Finance, 27(6), pp. 861-875. Levine, R., 1997. Financial development and economic growth: views and agenda. Journal of economic literature, pp. 688-726. Levine, R., Loayza, N. and Beck, T., 2000. Financial intermediation and growth: Causality and causes. Journal of monetary Economics, 46(1), pp. 31-77. Pagano, M., 1993. Financial markets and growth: an overview. European economic review, 37(2), pp. 613-622. Patrick, H. T., 1966. Financial development and economic growth in underdeveloped countries. Economic development and Cultural change, pp. 174-189. Wurgler, J., 2000. Financial markets and the allocation of capital. Journal of financial economics, 58(1), pp. 187-214. Appendix Regression Statistics Multiple R 0.984293 R Square 0.968833 Adjusted R Square 0.965587 Standard Error 85.96758 Observations 107 ANOVA   df SS MS F Significance F Regression 10 22054678 2205468 298.4223 1.19E-67 Residual 96 709480.8 7390.425 Total 106 22764159         Coefficients Standard Error t Stat P-value Lower 95% Upper 95% Lower 95.0% Upper 95.0% Intercept 6890.21 1262.714 5.456668 3.78E-07 4383.743 9396.677 4383.743 9396.677 X Variable 1 1.638535 1.618327 1.012487 0.31385 -1.57382 4.850888 -1.57382 4.850888 X Variable 2 -229.544 95.461 -2.40459 0.018109 -419.033 -40.0559 -419.033 -40.0559 X Variable 3 -39.6018 15.16041 -2.61219 0.010442 -69.695 -9.50864 -69.695 -9.50864 X Variable 4 -65.1216 36.90766 -1.76445 0.080838 -138.383 8.139562 -138.383 8.139562 X Variable 5 1083.308 146.4801 7.395598 5.28E-11 792.5475 1374.069 792.5475 1374.069 X Variable 6 -13.3076 13.41378 -0.99209 0.323649 -39.9338 13.3185 -39.9338 13.3185 X Variable 7 -3.92834 2.171694 -1.80888 0.073599 -8.23912 0.382439 -8.23912 0.382439 X Variable 8 30.51583 50.48639 0.604437 0.546979 -69.6989 130.7305 -69.6989 130.7305 X Variable 9 0.16806 0.053083 3.165981 0.002072 0.062691 0.273428 0.062691 0.273428 X Variable 10 45.21862 50.51358 0.895178 0.372931 -55.05 145.4873 -55.05 145.4873 EXPLANATORY VARIABLES X Variable 1:US & India SPOT RETURNCURRENCY X Variable 2: US & China Currency spread X Variable 3: US & Hong Kong govt. Bond spread X Variable 4: US & India govt. Bond spread X Variable 5: SPXS&P500INDEX X Variable 6: US financial conditions index X Variable 7: SPX S&P500INDEXRETURN X Variable 8: 90-Day AA Financial Commercial Paper Interest Rate X Variable 9: M2 Money Stock, Billions of Dollars, Monthly, Seasonally Adjusted X Variable 10: 3-month Treasury bill secondary market rate Read More