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Stock Markets, Banks and Economic Growth in a Context of Common Shocks and Cross-Country Dependencies

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  • Diego Ivan Ruge Leiva
  • Giuseppe Caivano

Abstract

Although a great deal of research has shown how stock markets and banks may relate to economic growth, such studies ignore the role that common shocks play in the finance-growth nexus. Using panels of 54 advanced and emerging economies, and novel common factor frameworks which account for dynamics, reverse causality, observed heterogeneities, and unobserved common shocks which cause error cross-sectional dependencies across countries, we find that stock market development has positive long-term effects on economic growth, while high levels of banking development might be detrimental to overall output. These results also hold for a subsample of advanced countries; however, despite the positive and significant effect that stock market development has on growth for a subsample of emerging countries, the negative effect of bank development is as likely to be significant as insignificant in this case. Moreover, we find that ignoring the strong error cross-sectional dependencies caused by common shocks and/or assuming homogeneous coefficients may yield inconsistent estimates.

Suggested Citation

  • Diego Ivan Ruge Leiva & Giuseppe Caivano, 2017. "Stock Markets, Banks and Economic Growth in a Context of Common Shocks and Cross-Country Dependencies," Working Papers 03/17, Instituto Universitario de Análisis Económico y Social.
  • Handle: RePEc:uae:wpaper:0317
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    File URL: http://www3.uah.es/iaes/publicaciones/DT_03_17.pdf
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    Keywords

    Economic Growth; Stock Market Development; Banking Development; Cross-Section Dependence; Multifactor Error Structure.;

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