The study examines the relationship between financial development and economic growth in Sierra Leone for the period 1970-2008. The method of principal components is employed to construct a financial sector development index (FSDI) used to proxy development in the sector. Using the autoregressive distributed lag (ARDL) approach, the study finds a unique cointegratingrelationship among real GDP, financialdevelopment, investment and real deposit rate. The results suggest that financial development exerts a positive and statistically significant effect on economic growth and investment is an important channel through which financial development feeds economic growth.
The relationship between financial development and economic growth has received considerable attention in the empirical growth literature. A large and growing amount of theoretical and empirical work has emerged following the pioneering work of Schumpeter (1911), who pointed out the productivity- and growth-enhancing effects of the services provided by a developed financial sector. He argued that financial intermediaries play a crucial role in fostering technological innovation and economic growth by providing basic services such as mobilizing savings, monitoring managers, evaluating investment projects, managing and pooling risks, and facilitating transactions.
Most of the literature has mainly focused on the role of macroeconomic stability, inequality, income and wealth, institutional development, ethnic and religious diversity and financial market imperfections (Christopoulos and Tsionas, 2004; Khan et al, 2005). Among these factors, it is well recognized that financial markets are crucial for economic growth. The seminal works of McKinnon (1973) and Shaw (1973) have supported Schumpeter’s view to promote development of financial sector for economic growth. The authors criticized the Keynesian or financial repressionist view adopted by many governments in developing countries in the early 1970s. They argue that government restrictions on the banking system such as interest rate ceiling, high reserve requirements and directed credit programs hinder financial development and reduce output growth. Similarly, the endogenous growth literature stresses the influence of financial markets on economic growth. Well developed financial markets promote investment and growth by channeling financial resources to the most productive uses.
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Financial Development and Economic Growth in Sierra Leone
