The Finance-Growth Nexus, again: New Evidence from Kenya

Abstract

The primary objective of this paper is to shed further light on the connection between financial development and economic growth in Kenya over the period 1960-2013. A Cobb-Douglas production function, augmented by incorporating financial development and other factors, is used. This paper uses a vector autoregressive (VAR) model to determine the causal relationship between financial development and economic development. Three alternative production function representations are proposed: a basic model including financial development and inflation along with capital and labour, a variant adding foreign direct investment (FDI), and a third focusing on the interaction between financial development and FDI. The results show that financial development is a by-product of growth. The interaction between FDI and financial development is causing growth. There is bidirectional causality between growth and the labour force. Policy-makers in Kenya can obtain fruitful impacts of FDI to enhance growth by improving the role of financial development. They may also need to improve the quality of labour to sustain growth.