De-jure Financial Liberalization and Economic Growth: An Empirical Analysis

This paper investigated the finance-growth nexus by adopting a novel approach for Pakistan. Firstly, we constructed a financial liberalization index by incorporating several time-varying financial frictions and reforms which is a manifestation of the de-jure financial liberalization process. Secondly, for examining the impact of financial liberalization on growth, we extended the Solow-Swan growth model to construct a financial sector augmented growth model. By incorporating the de-jure financial liberalization index, we examined the growth-finance linkages. By employing the Auto-Regressive Distributive Lag model and error-correction mechanism, the results of the study showed that de-jure financial liberalization provides momentum to economic growth in the short-run as well as in the long run. Empirical findings highlighted that moving towards a more liberalized financial system by reducing rigidities and expediting an effective reform process offers very hopeful prospects of economic growth in developing countries like Pakistan. Keywords: Financial frictions, Financial Reforms, Economic growth, Principal Component Analysis, ARDL Model