Abstract

The paper examined the empirical relationship between economic growth and financial development (FD) in Kenya over the period 1980–2011. The long-run and short-run parameters were estimated by use of autoregressive distributed lag (ARDL) bounds testing approach for co integration analysis. To determine the direction of causality, Granger causality analysis was done. Empirical findings indicate that there is stable long-run relationship among, financial development, trade openness and economic growth in Kenya. It also finds that financial development has a significant positive effect on economic growth. The magnitudes of the ECT coefficients suggest that the speed of adjustment in each of the estimated model is very high. The Granger causality tests showed that there is bi-directional causality between financial development and economic growth in Kenya for the period under study (1980–2011). This result therefore, supports both the supply leading, and demand following hypotheses. This means that financial development accelerates and augments economic growth in Kenya and that economic growth leads to development of the financial sector in Kenya. Thus, the government should strengthen the reforms in the financial sector so as to attract investors and improve the efficiency of all production activities in the country. At the same time, the government should enhance macroeconomic policies; fiscal policies, policies that attract foreign direct investment, and export promotion policies that on average lead to economic growth should.

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