The Impact of Financial Sector Development on the Economic Growth of Ethiopia

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.