The Relationship between Credit Market Development and Economic Growth

Problem statement: This study investigated the relationship between credit market development and economic growth for Spain for the period 1976-2007 using a Vector Error Correction Model (VECM). Questions were raised whether economic growth spurs credit market development taking into account the negative effect of inflation rate and investments on credit market development. This study aimed to investigate the short-run and the long-run relationship between bank lending, gross domestic product and inflation rate applying the Johansen cointegration analysis. Approach: To achieve this objective classical and panel unit root tests were carried out for all time series data in their levels and their first differences. Johansen cointegration analysis was applied to examine whether the variables are cointegrated of the same order taking into account the maximum eigenvalues and trace statistics tests. Finally, a vector error correction model was selected to investigate the long-run relationship between economic growth and credit market development. Results: A short-run increase of economic growth per 1% induced an increase of bank lending 0.08%, while an increase of inflation rate per 1% induced a relative decrease of bank lending per 0.56% and also an increase of investments rate per 1% induced an increase of bank credits per 0.18% in Spain. The estimated coefficient of error correction term was statistically significant and had a negative sign, which confirmed that there was not any a problem in the long-run equilibrium between the examined variables. Conclusion: The empirical results indicated that economic growth and investment have a positive effect on credit market development, while inflation rate has a negative effect. Bank development was determined by the size of bank lending directed to private sector at times of low inflation rates leading to higher economic growth rates.