There exist ample literature on economic growth and its determinants. Recent developments in growth theory have been primarily theoretical although significant progress has also been made in growth empirics. Among the determinants of economic growth, stock market development is increasingly becoming an important factor to impact upon it. The importance of stock markets lies in the contributions of it. Some of the facts in regard to the relationship between financial markets development and economic growth extensively discussed in the literature are as follows. First, at the initial stages of economic development, financial markets are undeveloped and very small in their magnitude.
During these stages, financial markets are primarily dominated by banks and other similar types of financial intermediaries. There is almost no role of stock markets or, even if they exist in any form, their size is negligible. Second, when financial intermediaries expand with capital accumulation, the number of sophisticated and more tailored financial instruments increases, as do the level of sophistication and complexity of financial contracts and the flow of resources and funds accruing to the financial market. Stock markets start developing both in terms of the number of listed firms and market capitalization. Third, when the economy continues to grow, equity markets develop further as well as the banking system. Similarly, other financial intermediaries also develop. Fourth, researchers recognize the common view that the stock markets appear to develop in a non-monotonic ways.
In economies where stock markets are relatively small, capital accumulation seems to be followed by a relative increase in banks? share in the financial system and in economies where the stock market has already reached a reasonable size, further development of the market causes an increase in the equity markets? share. In other words, evidence shows that the equity/debt ratio first decreases and, only with further development of the stock market, this ratio increases.
The phenomenal growth of equity markets during recent past along with the staggering growth in emerging equity markets have turned the focus of new literature towards the linkage between stock market performance and growth of an economy. However, there exists very little empirical evidence on the relationship between stock market development and long run economic growth. In the developing and emerging markets like Pakistan such evidence is almost zero with the exception of one study by Levine and Zervos (1998). Hence the importance of this study is justified.
The objective of this paper is to examine the effects of various determinants on economic growth with special focus on the effect of stock market development on it in Pakistan both in the short run and the long run. To the best of our knowledge, ours is the first attempt that undertakes a study where ARDL-bounds testing (Autoregressive Distributive Lag Model) is applied utilizing the small time series data covering the period from 1971-2006. Hence it is a contribution to the existing literature.
The rest of the paper is organized as follows; section 2 reviews the literature, section 3 explains the model, data and methodological framework, section 4 presents the results and interpretations; and section 5 deals with conclusions and policy implications.