Abstract:
The main macroeconomic objectives of most developing countries including Ethiopia are
sustained economic growth with sound financial system. Many researchers are interested to
analyze the relation between economic growth and financial development. This study also
examines the impact of financial sector development on economic growth of Ethiopia based on
VAR model using time series data from the year 1975 to 2017. The methodologies used in this
study are the co integration, Granger causality, vector error correction model test, and Impulse
response function and variance decomposition test. Real GDP growth was used as a proxy for
economic growth and M2 GDP ratio, PSC GDP ratio and deposit interest rate as proxies for
financial development to examine the relation. A stationary test was carried out using
Augmented Dickey Fuller test (ADF) all variables are stationary at first difference. The Johnson
co integration test using Trace statistic and Maximum Eigen value test result showed that there
was long run co integrating relationship between financial development indictors and economic
growth.
The empirical result shows that M2 _GDP and PSC_GDP are significant both in short run and
long run relationship between financial development and economic growth. The results of
Impulse response and variance decompositions also indicate the permanent effect of financial
development on economic growth. The policy implication is that long-run policies of financial
development are believed to provide significant effect on economic growth.
