Financial Development and Economic Growth in Sri Lanka
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vector error correction
A well-developed financial sector can affect a country’s economic development by channeling financial resources in the most productive way and by providing sufficient credit to the private sector for investments. Studying the relationship between financial development and economic growth has become increasingly important. Although there are a significant number of studies on this subject, ideas about the relationship between financial development and economic growth are controversial due to mixed results. The theoretical background to this relationship has a long history. In 1911, Schumpeter argued that financial development plays an essential role in economic development because intermediary financial institutions have the capacity to allocate savings to more productive investments that promote economic progress. Other empirical studies have shown unidirectional, bidirectional or no relations between these two factors.
Sri Lanka introduced reforms to its financial sector in 1977 by implementing an open economic policy. Therefore, studying the relationship between financial development and economic growth in this country is important. The objective of this study is to examine the relationship between financial development and economic growth in Sri Lanka for the period 1952 to 2014. After considering time series characteristics of the data, this study employs vector error correction methodology. This study uses five variables: real per capita GDP, ratio of broad money to GDP, ratio of investments to GDP, deposit interest rate in real terms and trade ratio.
The results of this study confirm that there is a unidirectional relationship from financial development to economic growth in Sri Lanka. In addition, the investment ratio and trade ratio negatively affect the real per capita GDP and broad money ratio, while the deposit interest rate positively affects both variables. There are two cointegrating relationships among the five variables, and the error correction coefficients show economically and statistically significant results. The error correction coefficient of the GDP relationship is -0.0430 while error correction for broad money supply is -0.3693.
This study highlights the importance of developing the financial sector in Sri Lanka to increase the growth of the country’s GDP. The interest rate has become the significant factor for GDP growth and for implementing monetary policy. The open economic policy has significant effect on money supply, and money supply affects the economic growth in the short term. Therefore, policy makers should consider about the time range in making policies.
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