Effect of Financial Development on Economic Growth: Does Inflation Matter? Time Series Evidence from the UEMOA Countries

Abstract

An important issue in the finance and growth literature is whether the strength of the relationship between finance and growth may depend on inflation rate. This paper uses time-series data to examine this evidence for seven African countries. The technique of principal component analysis is used to construct an overall index for financial development. This summary measure is used to estimate nonlinear growth equations. The empirical findings did not provide significant evidence of nonlinearity in the finance-growth relationship. Financial development has no significant effect on economic growth regardless of the level of inflation.

Keywords:

• Financial development
• economic growth
• inflation
• threshold effects

JEL Classifications:

• E44
• C22
• O16

Acknowledgements

The authors would like to thank an anonymous referee for useful comments on an earlier version of this paper. Any remaining errors are our own.

Notes

¹See Levine (1997) for a comprehensive survey of the literature.

²In Rousseau and Wachtel's (2002) study, financial development has a positive effect on growth only when inflation falls below a threshold that varies between 13% and 25% depending on the financial development indicator. These results have obtained using cross-section regressions. Lee and Wong (2005) addressed the threshold inflation rate for Taiwan and Japan using time-series data. The threshold level of inflation below which financial development significantly promotes growth is estimated at 7.25% for Taiwan and 9.66% for Japan.

³For more technical details see Lebart et al. (1995).

⁴The results are not reported here to conserve space. They are available upon request.