Credit Market Development and Economic Growth an Empirical Analysis for United Kingdom

Problem statement: This study investigated the causal relationship be tween credit market development and economic growth for UK for the period 1975-2007 using a Vector Error Correction Model (VECM). Questions were raised whether economic growth spurs credit market development taking into account the negative effect of inflatio n rate on credit market development. This study aim ed to investigate the short-run and the long-run relat ionship between bank lending, gross domestic product and inflation rate applying the Johansen cointegrat ion analysis. Approach: To achieve this objective classical and panel unit root tests were carried ou t for all time series data in their levels and thei r first differences. Johansen cointegration analysis was ap plied 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 select ed to investigate the long-run relationship between economic growth and credit market development. Results: A short-run increase of economic growth per 1% induces an increase of bank lending 0.006%, while an increase of inflation rate per 1% induces a relative decrease of bank lending per 1.05% in UK . The estimated coefficient of error correction ter m is statistically significant and has a negative sig n, which confirms that there is not any problem in the long-run equilibrium between the examined variables. Conclusion: The empirical results indicated that there is a unidirectional causal relationship betwe en economic growth and credit market development with direction from economic growth to credit market development and a bilateral causality between inflation and credit market development for United Kingdom. Bank development is determined by the size of bank lending directed to private sector at times of low inflation rates leading to higher economic growth rates.