The Nexus between Economic Growth and Financial Development: The Case of Ethiopian Economy

Abstract

This research tries to examine the effect of financial sector on the economic growth of Ethiopia over the period of 1980-2013. The paper uses ordinary least square method to determine both long-run and short-run effects of financial development on economic growth. It uses commercial-central bank asset ratio as an indicator of financial development where as variables such as openness, lagged real GDP, total investment, aid and labor force were used as conditioning variables. As to the trends of growth and financial sector of the country, Ethiopia has been experiencing strong economic growth compared to early years; the major financial institutions operating in Ethiopia are banks, insurance companies and micro-finance institutions and the financial sector of the country shows a slightly optimistic sign of growth but the performance of the financial sector of Ethiopia as compared to other middle-income African countries shows the need for more improvement. The empirical investigation shows a negative and significant effect of financial development indicator (i.e. commercial-central bank asset ratio) on the economic growth of Ethiopia. In addition, the regression results indicated that the conditioning variables openness and labor force showed an expansionary effect on the Ethiopian economy where as aid showed a significantly negative effect on the economic growth. Generally, the result of the study indicates that economic growth of Ethiopia is significantly influenced by financial sector development.