The Causality between Financial Development and Economic Growth: The Case of Turkey

(ProQuest: . denotes formulae omitted.)1. IntroductionThe relationship between financial development and economic growth has been one of the most investigated subjects in economic literature for a long time. According to Schumpeter (1911), who was one of the first economists to discuss the effects of financial system on economic growth, banks enable resources to be allocated to innovative and productive fields by providing credits to firms. Thus, banks play an important role in economic development by enabling technological innovations. This view, which is based on Schumpeter (1911), is called as "supply leading hypothesis" by Patrick (1966). In economic literature, another view, which has been led by Robinson (1952), argues a causal relationship from economic growth to financial development. According to this view, as the economy grows, demand for financial institutions and tools will increase, and therefore economic growth will cause development of the financial system. This view is termed "demand following hypothesis" by Patrick (1966), which proposes a causal relationship from economic growth to financial development.Until the beginning of 1990s, "Financial Repression School" suggested explanations to the effects of financial development on economic growth. According to McKinnon (1973) and Shaw (1973), the pioneers of Financial Repression School, policy implementations such as interest rate ceilings and keeping required reserve ratio at high levels restrain financial development and hence the economic growth. However, opposite implementations that liberalize financial system are expected to result in higher level of savings and productive investments, which increase the ratio of economic growth.In the beginning of 1990s, the causal relationship from financial development to economic growth is started to be explained in the literature of the endogenous growth models. According to the endogenous growth models, the services provided by financial markets and instruments are assumed as endogenous variables. Financial development leads to economic growth through two channels. First, financial system provides funds for investments through mobilizing of savings, which leads to capital accumulation. Second, financial system monitors the investment projects, which help the spillover of information possessed by economic units and enhance total factor productivity. Capital accumulations and enhancing total factor productivity cause economic growth (Greenwood and Jovanovic, 1990; Bencivenga and Smith, 1991; King and Levine, 1993b; Pagano, 1993; Greenwood and Smith, 1997). In the related literature, it has been put forward that the causal relationship between financial development and economic growth can change its direction throughout the development process. According to this view argued by Patrick (1966), supply leading hypothesis is valid for the earlier stages of a country's development, while demand following hypothesis is valid for the latter stages. In earlier stages of development, services provided by the financial system accelerate technological development and the rate of economic growth increases. As development proceeds, economic growth increases demand for financial instruments and lead to development of financial system.In the literature, besides the studies that support supply leading and demand following hypotheses, there are also those which support that there is no causal relationship between financial development and economic growth. For example, Lucas (1988) argues that monetary changes do not have any effect on economic growth, and therefore there is no causal relationship between financial development and economic growth.The purpose of our study is to investigate the existence and the direction of the long run and short run causal relationships between financial development and economic growth in the 1987:1-2012:4 period in Turkish economy. Our study aims to contribute to the literature, in which there are many different views, with new evidence. …