Exam (elaborations)

The Bounds Test Approach for Cointegration and Causality between Financial Development, International Trade and Economic Growth: The Case of Cyprus

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Cointegration

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The Bounds Test Approach for Cointegration and Causality between
Financial Development, International Trade and Economic Growth:
The Case of Cyprus

Hatice Pehlivan JENKINS* and Salih Turan KATIRCIOGLU*

Author`s Contact Address:

Hatice Pehlivan JENKINS, Asst.Prof.Dr.
Department of Banking and Finance
Eastern Mediterranean University
P.O. Box 95, Famagusta, North Cyprus
Via Mersin 10, TURKEY

Tel: +90 392 630 1476
Fax: +90 392 630 2825
e-mail: hatice.jenkins@emu.edu.tr

Salih Turan KATIRCIOGLU, Asst.Prof.Dr.
Department of Banking and Finance
Eastern Mediterranean University
P.O. Box 95, Famagusta, North Cyprus
Via Mersin 10, TURKEY

Tel: +90 392 630 2008
Fax: +90 392 365 630 2032
e-mail: salihk@emu.edu.tr

*
Authors contributed equally to the article and are listed in alphabetical order.

1

,The Bounds Test Approach for Cointegration and Causality between Financial
Development, International Trade and Economic Growth: The Case of Cyprus

ABSTRACT

This study employs the bounds test for co-integration and Granger causality tests to

investigate the long-run equilibrium relationship between financial development,

international trade and real income growth. Furthermore we are intersting in finding the

direction of causality among these economic variablesfor the Cyprus economy. The

results of the study reveal that financial development as measured by broad money (M2),

international trade and real income growth are co-integrated; thus, a long-run equilibrium

relationship can be inferred for these three variables. On the other hand, Granger

causality test results suggest that in Cyprus the growth in real income stimulates the

growth of international trade (both exports and imports) and the money supply.

Furthermore, growth in imports of goods and services also stimulates an increase in

exports of goods and services of Cyprus. Although this result contradicts our initial

expectations it indicates the importance of capital inflows in Cyprus that played a major

role in financing the investments mainly in the tourism sector. Thus, results of this study

reveal that the supply-leading, export-led growth, and import-led growth hypotheses are

not confirmed by this study whereas the demand-following hypothesis can be justified for

the Cypriot economy when M2 measure of money supply is under consideration.

2

, I. INTRODUCTION

Among the main issues of development economics is to investigate the major

determinants of economic growth. The relationship and the direction of causality between

financial development and economic growth have been empirically tested in the

literature. After the extensive studies in this field, it is now well recognized that financial

development is crucial for economic growth (Calderon and Liu, 2003) as it is a necessary

condition for achieving a high rate of economic growth (Chang, 2002) and has a strong

positive relationship with economic growth (Mazur and Alexander, 2001). However,

according to De Gregorior and Guidotti (1995) financial development significantly

reduces economic growth for countries (especially in Latin America) experiencing

relatively high inflation rates. Thus, this causal relationship generally remains unclear

(Calderon and Liu, 2003).

In the early studies of economic development, relatively little attention was paid to the

financial aspects of the process and the role of the financial sector was underestimated by

economists. In the 1960s, however, the relationship between financial development and

economic growth started to be explored in the pioneering studies of Gurley and Shaw

(1955, 1967) and Goldsmith (1969). Following these studies a substantial amount of

work has been done by different writers, such as Patrick (1966), Khatkhate (1972 1988),

McKinnon (1973), Shaw (1973), Fry (1978, 1986, 1988), Gupta (1984) and Wijnbergen

(1982, 1985). The relationship between financial development and economic growth has

3

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