Abstract:
During the last two decades, there has been a large amotmt of empirical work examining the
relationship between financial development and economic growth. However, the findings of
these studies indicate that there is no consensus on the effect of fmancial development on
economic growth. In the empirical literature, some argue that an efficient financial sector
leads to economic growth while others maintain that it is growth that leads to financial
development. Others provide evidence that there is a two way-causality between financial
sector development and economic growth while others find no relationship between financial
development and economic growth. In addition, a significant number of these studies use
panel and cross-sectional data to examine the link between economic growth and financial
development. These studies have limitation in that they may not adequately capture the
specific effects of a particular country. Moreover, these countries may have different levels of
economic and financial development. It is against this backgrolmd that fluis study was carried
out to empirically investigate the short and long-nin effect of financial development on
economic growth in Kenya using annual time series data over the period 1970 to 2012. This
study was informed by the neoclassical growth theory. This study employed modem
econometrics techniques such as test of unit root using Philip Perron, bounds test of co
integration approach in autoregressive distributed lag (ARDL) model to examine the
relationship between financial development and economic growth. The results of this study
revealed that financial development exerts a positive and statistically significant efi'ect on
economic growth in Kenya hence confirming supply leading hypothesis. This was confirmed
by both measures of financial development in the short-run as well as in the long-run. From
policy perspective, the policy makers need to formulate financial sector reform policies to
ensure a well-fimctioning financial system that promotes domestic credit especially to
productive sectors of the economy. This will consequently promote economic growth and
help in realizing the millennium development goals as well as the government’s vision 2030.
