Abstract

The direction of causality between financial sector and economic growth has remained contentious in Ethiopia. This study investigated their linkage for the period of 1980 to 2014. Granger causality test revealed the existence causality that runs from financial sector to economic growth and not the vis-a-versa, while Johnson cointegration analysis confirmed the existence of long-run relationship between financial sector, labor, foreign aid and economic growth. In the short run, however, saving and foreign aid had impact on economic growth. The error correction indicated a full adjustment to the long run equilibrium takes 10 years. The study implies the need for appropriate financial sector development policy, and setting up of appropriate strategy for saving mobilization, increased foreign direct investment and reduction of heavy dependence on foreign aid.

Key words: Vector auto regressive, Johnson cointegration, Granger causality, impulse response, short run dynamics, financial sector development, economic growth, Ethiopia.