Is finance-growth nexus nonlinear? : evidence from linear and nonlinear causality analysis

This chapter examines the direction of causality between financial development and economic growth in 44 developed and developing countries for the period of 1965-2016. Using bank-based indicators, our empirical results provide the evidence of linear Granger-causality running from economic growth to financial development in most of the countries, supporting demand-side hypothesis. On the contrary, using stock market-based indicators we find the evidence of unidirectional causality running from financial development to economic growth, supporting supply-side hypothesis. Further, using nonlinear causality test, we observe that a half of the sample countries do not show causality between bank-based financial development and economic growth in either direction, following neutral hypothesis. However, rest of the sample countries show significant nonlinear causality in different directions depending upon the indicators employed. Similarly, employing stock market indicators, we find insignificant nonlinear Granger-causality between financial development and economic growth. Moreover, comparing countries by their inflation level, we find significant linear and nonlinear causality running from financial development to economic growth, supporting supply-side hypothesis in low inflation countries. The high inflation countries show mixed results in the direction of Granger-causality. Similarly, the chapter using stock market indicators confirms both linear and nonlinear causalities from financial development to economic growth in low inflation countries. Further, using bank-based indicators the linear and nonlinear Granger-causality result confirms insignificant Granger-causality in both high income and low income countries. Interestingly, medium income countries show significant nonlinear Granger-causality from financial development to economic growth. But using stock market indicators, we find significant linear Granger-causality from financial development to economic growth.