The Rule of Banking System Development in Economic Growth : The Case of Iran

Abstract

<em>This paper empirically investigates the relationship between banks and economic growth emphasizing the transmission channels from financial development to growth in </em><em>Iran</em><em> using time series methodologies, namely Johansen's co-integration and Granger causali</em><em>ty </em><em>methods</em><em> in the context of </em><em>error correction models</em><em> (</em><em>ECM</em><em>). The results show that in our case study banks affect economic growth mainly through the capital accumulation channel. </em><em>Because of financial backwards and market imperfections, </em><em>agents face </em><em>many</em><em> borr</em><em>owing constraints</em><em>,</em><em> which may hinder the</em><em>ir</em><em> ability </em><em>to</em><em> invest at optimal levels.</em><em>In</em><em> this situation</em><em>,</em><em> the role of banking system in increasing investment</em><em> through</em><em> capital accumulation is expected to be strong. </em><em>In our study, we do not find an evidence for </em><em>produ</em><em>ctivity channel, perhaps reflecting inefficiency of the Iranian banking system</em><em>, which imposes many</em><em> restrictions on bank choices </em><em>such as</em><em> credit rationing and directed finance under financial repression. </em><em>O</em><em>ur results strongly support the supply-leading </em><em>hypoth</em><em>esis</em><em>. </em><em>The main policy message of the paper is that banking system development matter</em><em>s</em><em> for </em><em>investment and</em><em> economic growth in </em><em>Iran</em><em>.</em><em>Therefore, policies that affect financial system are also likely to influence investment and economic growth.</em>