An Aggregate Import Demand Function: An Empirical Investigation by Panel Data for Latin American and Caribbean Countries

Abstract

The present paper empirically investigates the validity of the question whether financial sector's development contributes to economic growth in a small developing economy like Pakistan. The paper employs a relevant measure of financial development that meets the requirements of the finance-growth theory. The dynamic relationship between per capita GDP and financial development is investigated by employing two advanced techniques, 'FMOLS' and 'DOLS' to test the robustness of the long-run relationship after testing the order of integration of the variables. Empirical findings suggest existence of stable relationship between per capita GDP and financial development. Regression results of FMOLS reveal that financial sector's development improves the performance of the economy in the long run, but declines economic growth in the short run. Credit to private sector as a share of GDP, used as a proxy for financial development, is a good predictor of economic growth in the long run, in case of Pakistan. The results reveal that rise in exports also boosts economic growth in the long run, and investment stimulates economic growth both in the long run as well as short run, through its direct and indirect channels. Inflation and imports both reduce economic growth. And finally, high economic growth is found to be associated with small size of the government. (ProQuest: ... denotes formulae omitted.) Introduction An efficient financial sector allocates funds with ease to the entrepreneur or corporation for their sound projects, that in turn stimulate the economic growth. Thus, a developed financial sector is a must for providing broader access to finance at lower costs. The empirical literature in a cross-country framework employing different statistical procedures and dataset has demonstrated positive effects of financial development on economic growth. Goldsmith (1969), using correlation between financial development and economic development, first tested the relationship between finance and economic growth. He utilized the ratio of the value of financial intermediary assets to Gross Domestic Product (GDP) as the only measure of financial development. Studies by Rajan and Zingales (1998) and Levine et al. (2000) have reexamined the relationship between financial development and economic growth on two fronts. First, they have used more appropriate measures of financial development such as the liquid liability to GDP ratio, the credit to private sector as a share of GDP, the level of stock market turnover, and the quality of accounting standards as a measure of a firm's ability to raise funds. Second, they went beyond the simple correlation between finance and growth by using, multiple regression models, dynamic panel estimation, and finally, instrumental variables method. The link between financial development and economic growth can also be found in country case studies. The most influential work was done by McKinnon (1973), who studied the relationship between financial systems and economic growth in Argentina, Brazil, Chile, Germany, Indonesia, Korea and Taiwan in the post World War II period. He concluded that better functioning of financial system supports faster growth.1 Pagano (1993) suggested that financial sector affects economic growth by increasing the productivity of investment, lowering the transaction cost, and also affects savings. Some explored theoretical models describe that financial markets and institutions improve the quality of investment projects, which in turn boost economic growth (Greenwood and Jovanovic, 1990; and Saint-Paul, 1992). Hussein (1999) confirmed the importance of financial sector for economic growth and concluded that a rise in the ratio of private credit to total credit leads to economic growth. Interest rates may have a positive impact on savings, but the overall effect of interest rate on growth is ambiguous (Hussein, 1999). McKinnon (1973) and Shaw (1973) argued that liberalization from restrictions such as interest rate ceilings, high reserve requirements and selective credit programs, facilitates economic growth. …

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