Financial development and economic growth: evidence from the European Union

The purpose of this paper is to detect the relationship between finance and growth in the European Union countries, by searching the direction of causations.

The growth of real sector is expressed by real GDP per capita growth (dgdpcap), while the size of the financial system by the ratio of domestic credit to GDP (domcregdp). The deposit rate and inflation are used as indexes of monetary policy. This paper estimates vector autoregressive models, based on the Akaike information criterion (AIC) and the Schartz criterion (SC) criteria and cointegration tests are conducted. To test for stationarity, the paper uses Im, Pesaran and Shin (IPS) test. In case with variables are integrated of order one I(1), the paper tests whether they are cointegrated using Pedroni's methodology.

In the short run, the size of the financial system does not directly seem to affect growth, although its increase seems to lead to an increase in the deposit rate and consequently to a decrease in real GDP per capita. However, according to the vector error correction estimates, the significance of the error correction coefficients implies that there is a relationship between real sector, financial sector and monetary policy in the long run.

Pedroni's methodology, which allows for heterogeneity across members and residual serial correlation, is used for the first time, in Europe, regarding the above‐mentioned variables. According to the results, there seems to be a long‐term relationship, between finance, growth and monetary policy.