Empirical analysis of the linkage between Financial development and Economic Growth in Ethiopia

This paper investigates the dynamic linkage between financial development and economic growth in Ethiopia during the period from 1980/81 to 2021/22 using Time series data. The long-run and short-run parameters is analysed with a use of Autoregressive Distributed Lag (ARDL) bounds testing approach for co-integration analysis. To determine the direction of causality, Granger causality analysis has been done. The study includes savings and investment as intermittent variables in an attempt to address the omission of variable bias – thereby creating a multivariate Granger-causality model. Using the newly developed autoregressive distributed lag bounds testing approach to co-integration and the error-correction model-based causality model, the study finds that a bi-directional relationship exists between economic growth to financial development. This implies that past values of economic growth of Ethiopia are useful when we forecast the development of the financial system. This finding is consistent with Patrick’s (1966) Demand-following hypothesis which postulates a causal relationship from economic growth to financial development. That is, as the economy grows, the demand for financial services might lead to the expansion of the financial sector. Therefore, The study concluded that all independent variable: domestic private sector credit, domestic saving, inflation, investment, interest rate spread, government expenditure and trade openness had a statistically significant linkage with economic growth for the period under consideration. Based on the findings and conclusions, the study recommends that; National Bank of Ethiopia shall be able to promote new banks to join the financial environment, short-run policy makers are advised to focus on long-run policies such as improving the financial markets and introducing capital markets, lower the interest rate spread between the average lending and deposit rates, adopt a fiscal policy that encourages the increment of government spending on growth-inducing activities to drive economic growth and encouraging the saving habit of the public