Financial Intermediation and Economic Growth: A Lesson from Sri Lanka

Abstract

The relationship between finance and growth has been well documented in the economic literature. A considerable body of theoretical literature suggests a strong and positive link between financial development and economic growth. The purpose of this study is to examine whether financial intermediation leads to economic growth in a small open economy of Sri Lanka using time series macro data for the period 1977-2008. This basically investigates the channel and the effect of financial intermediation to economic growth with a new framework. The model framework of the study develops as per the endogenous growth theory. The model explains the joint effect of financial intermediation, trade openness and other economic factors on economic growth in Sri Lanka. This paper uses Engle-Granger two step methodologies to find out long term relationship between financial intermediation and economic growth. And, short run dynamic of the model is explained by granger causality test. The findings of the study revealed that financial intermediation impact on economic growth in the long run but the relationship is not strong. Further, study reveals that financial intermediation promotes growth through the productivity channel rather than accumulation of capital.