Discussion Paper

No. 2019-11 | February 11, 2019
The effects of income and inflation on financial development: evidence from heterogeneous panels


This paper examines four unresolved issues regarding the effects of GDP and inflation on financial development: (i) Does GDP have uniform impact on financial development in heterogeneous income countries? (ii) Is the relationship non-linear? (iii) Does financial development vary with inflation rates? (iv) Does inflation moderate the effect of GDP on financial development? The authors employ the newly developed dynamic Common Correlated Effects (CCE) and dynamic panel system Generalized Method of Moments (GMM) on data from 125 countries. These techniques enable us to control for cross-sectional dependence, heterogeneity and endogeneity. They show that GDP has a positive impact on financial development in high and middle-income countries, and the relationship is non-linear in over 60% of the countries. The authors also reveal that inflation has a negative effect on financial development in high- and medium-inflationary countries. Besides, high inflation moderates the effect of GDP on financial development in over 70% of the countries. They also show the countries where higher GDP is better for financial development and where it is not. They recommend some policy options based on the findings.

JEL Classification:

G15, F10, E31


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Cite As

Kizito Uyi Ehigiamusoe, Vinitha Guptan, and Suresh Narayanan (2019). The effects of income and inflation on financial development: evidence from heterogeneous panels. Economics Discussion Papers, No 2019-11, Kiel Institute for the World Economy. http://www.economics-ejournal.org/economics/discussionpapers/2019-11

Comments and Questions

Kizito Uyi Ehigiamusoe, Vinitha Guptan, and Suresh Narayanan - Comments on the papers
February 15, 2019 - 04:35

This paper aims to discuss the GDP-financial development by considering the impacts of inflation. While the findings, in general, are in line with the economic theories. There are some points that the author might need to consider to improve the paper.

1) Equation 4 to measure the variance of ...[more]

... GDP marginal effect could be incorrect.
2) The author can report Lind and Mehlun (2000) U-test to prove further evidence for the existence of nonlinearity.
3) P.10 (linear GDP in column 3 of Table 2 is actually positive while the squared term of GDP should be negative)
4) The coefficients of interaction term are statistically insignificant. Hence, it is more appropriate to highlight that there is no statistical impact from inflation on the linkage between GDP and FD (p.12).
5) In the robustness checks, the author could elaborate whether the impact of GDP and inflation have the same sign as the initial estimations.
6) In the conclusion, the non-existence of nonlinearity is not mentioned.
7) The policy implications are rather simple. High economic growth usually comes with high inflation. More explanations about the collaborations between fiscal and monetary policies to make high economic growth to happen during low inflation will make the policy implications more informative.

Kizito Uyi Ehigiamusoe - Reply to Dr. Chee-Hong Law
March 17, 2019 - 09:28

Thank you very much for your comments Dr. Chee-Hong Law.
1. We have corrected the minor typo error in Equation 4 in our revised manuscript
2. In the original manuscript, we actually conducted a non-linearity test between financial development and GDP using the U-test proposed by Lind and Mehlun (2010), ...[more]

... but we didn’t comment on it due to want of space. Based on your comment, we have now commented on the U-test result with a footnote in the revised manuscript.
3. The statement on P.10 is correct because it refers to Column 3 in middle income and low income panels where the coefficient of linear GDP is negative and the coefficient of GDP squared is positive. However, for clarity sake, we add the explanation for high income group where the coefficient of the linear GDP is positive and the coefficient of GDP squared is negative.
4. The coefficient of the interaction term is negative and significant in middle income countries by insignificant in high and low income countries. This is highlighted in the paper.
5. We have made it clearer in the revised manuscript that the results of the robustness checks are similar to the results obtained with private sector credit in terms of sign and significance.
6. We have also clarified that although there is no robust evidence of a non-linear relationship between GDP and financial development in the heterogeneous panels, we found some evidences of non-linear relationships in some countries.
7. In the revised manuscript, we have added a new section on "Discussion and Policy Implications" where we strengthened the discussion on our findings and the policy implications of the study.

Once again, thank you Dr. Chee-Hong Law.

Anonymous - Referee Report 1
March 08, 2019 - 12:56

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Kizito Uyi Ehigiamusoe, Vinitha Guptan, and Suresh Narayanan - Reply to Referee Report 1
March 15, 2019 - 12:20

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Anonymous - Referee Report 2
March 29, 2019 - 10:26

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Kizito Uyi Ehigiamusoe, Vinitha Guptan, and Suresh Narayanan - Reply to Referee Report 2
April 05, 2019 - 11:41

See attached file