Financial development, economic growth and the role of fiscal policy during normal and stress times: Evidence for 26 EU countries

Abstract

This article empirically explores the finance-growth relationship and the performance of the financial system measured by financial depth, accessibility, and efficiency of both financial sectors, that is, institutions and stock markets.It also examines the role of fiscal policy in conjunction with the performance of financial development during both normal and stress times. The data consists of a panel of 26 European Union countries over the period 1990-2020.The results show that during normal times, the finance-led growth relationship and the stock market are greatly important, while during stress times the relationship becomes insignificant. Interestingly, financial institutions are found to be more effective at promoting growth and there is clear evidence that a potentially dynamic positive effect of institutions to growth is absorbed by macroeconomic shocks. In addition, there is evidence for a threshold at a lower level compared to those previously identified in the literature. This latter finding can be attributed to different measures of financial institutions used and the impact of macroeconomic shocks. The inability of both financial sectors to enhance economic activity seems to exhibit persistence from the occurrence of the global financial crisis until the onset of the recent Covid-19 pandemic.

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