FINANCIAL DEVELOPMENT AND ECONOMIC GROWTH IN THE PRESENCE OF SIMULTANEITY BIAS: PANEL DATA EVIDENCE
FINANCIAL DEVELOPMENT AND ECONOMIC GROWTH IN THE PRESENCE OF SIMULTANEITY BIAS: PANEL DATA EVIDENCE

Summary/Abstract: Does financial development positively contribute to economic growth? One line of research argues that financial development is a positive contributor to growth. However, other studies show that financial development is not necessary for economic growth. An important contribution of this paper is that it estimates the correlation between financial development and economic growth after accounting for simultaneity bias. I employ the Principal Component Analysis to construct a composite financial development indicator based on four financial development variables. Due to the demand-following hypothesis which states that economic growth causes financial development, I conduct an endogeneity test on the composite financial development indicator and the results suggest that financial development is endogenous. Using the random effects instrumental variable estimation and the past values of the composite financial development indicator to account for simultaneity bias, I find that financial development remains a positive and relevant contributor to the long-run economic growth of developed countries.

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