Financial Development, Financial Instability and Poverty: A Novel Appraisal in the Presence of Structural Changes

Abstract

This paper attempts to investigate the causal linkages between financial development, financial instability and poverty in Pakistan in the presence of structural changes. In addition to conventional finance growth relationship, this study presents empirical evidence whether credit expansion paves the way for financial instability, which in turn causes macroeconomic volatility. To incorporate the probable influence of structural changes identified by (Perron, 1989; Zivot and Andrews, 1992) unit root tests with structural breaks. We utilized ARDL bounds testing and (Gregory and Hansen, 1996) cointegration with structural breaks followed by (Hsiao, 1981) version of granger causality. We find the poverty reduction effects of financial development in the both short and long run. In contrast financial instability and real sector show insignificant coefficients. Furthermore, evidence of unidirectional causality departs from growth to finance confirmed by ADL model; however Hsiao's test reports bidirectional causality. We also show that financial development reduces financial instability while macroeconomic volatility stimulates it. Besides, we perform cointegration and causality analysis in the both bivariate and multivariate frameworks.

Keywords: Financial Development, Financial Instability, Poverty, Structural breaks

JEL Classification: E51, O16