Financial Development and Economic Growth: The Role of the Stock Markets

The relationship between financial markets and economic growth has interested economists for decades. However, previous studies do not identify the unique role of stock markets in economic growth, nor do they test explicitly if stock markets affect the level or the growth rate of the economy. Several theoretical and empirical papers by Levine (1991), Levine and Zervos (1995), Kunt (1992), and Kunt and Levine (1996) have contributed to our understanding of how stock market development may affect economic growth, but the common problem with them all is that no channel through which stock markets can stimulate economic growth is explicitly identified.

This thesis deals with two issues concerning the relationship between stock markets and economic growth. The study examines the nature of the causal link between stock markets and economic growth using Toda and Yamamoto (1999) technique in testing for causality relationship between the variables concerned. Focusing on the nature of causality between stock markets and economic growth, the study examines the endogenous growth hypothesis that fmancial markets enhance economic growth performance specifically through the level and productivity of investment.

In the empirical part of the study, we analyze stock market data from seven countries over 1979-1995. We use time-series analysis, and find that the development of stock markets has a significant effect on the growth rate of real GDP. We also find evidence that supports the endogenous growth hypothesis, where the level and productivity of investment are important channels through which stock markets enhance economic growth.

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