Long Run and Short Run Linkages Between Credit and Output: An Appraisal of the Districts of West Bengal in India

Long Run and Short Run Linkages Between Credit and Output: An Appraisal of the Districts of West Bengal in India

Ramesh Chandra Das (Vidyasagar University, India) and Bankim Ghosh (Katwa College, India)
Copyright: © 2021 |Pages: 14
DOI: 10.4018/IJABIM.20210401.oa7
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Abstract

An appropriate link between the financial sector and real sector is required to have a balanced growth and development of a country as well as its regional levels particularly for the countries whose financial developments are not being saturated. In the present study, the authors have examined whether there are long run equilibrium relation between financial development (proxied by commercial bank credit) and real sector's development (proxied by net district domestic products) and short run causations for the districts of the state of West Bengal in India for the period 1993-2014. Applying the Engel-Granger cointegration and Granger causality approaches, the study reveals that there are cointegrating relations between credit and domestic products of the 13 districts out of which errors are corrected for 10 districts. Further, there are unilateral causal relations between the variables in nine districts with 11 producing no such causal relations. The study thus prescribes for strengthening the two sectors' developments so that there can be appropriate linkages between credit and output across the district levels in the longer runs.
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Introduction

Whether financial institutions do have any significant impact on the real sectors of the economy has been the subject of discussion and debate among the economists of different schools. Adam Smith (1789) did not believe that the financial institutions have any influence upon the production activities of the real sectors and so growth of a nation. Smith, in his famous book, “Wealth of Nation” has pointed out that farmers, producers and businessmen are the important carrier of economic growth. To him, roles of business enterprises, competition and free trade would be to lead the farmers, producers and businessmen to expand market size and which, in turn, would stimulate economic development. Schumpeter (1911), on the other hand, postulated the reverse argument. According to him, economies make progress through the trade cycle in a dynamic and discontinuous system. In order to break the circular flow the workings of the innovative entrepreneurs are to be financed by banking funds. Therefore, bank credit can have great impact on the growth of the real sectors of the economy. In another work, Schumpeter (1934) highlighted the importance of financial intermediaries in mobilizing savings, evaluating projects, diversifying risks, monitoring management of firms in debt, and facilitating transactions which are essential for innovation and economic growth. Patrick (1966) is probably the first to clearly define the one-to-one correspondence between bank credit and growth of aggregate output, especially for the underdeveloped countries. According to him, there are two ways of explaining the inter-linkages among the bank credit and growth of domestic product. One of them is the Supply Leading Approach (SLA) and the other is the Demand Following Approach (DFA). Under SLA it is argued that credit behaves like one of the usual traditional inputs of production and so expansion of credit may lead to growth of domestic product of a country. On the other hand, under DFA, it is assumed that the financial development of a country is an offshoot of the development of the real sector. Alternatively it can be said that expansion of credit facility of a nation depends on its expansion of its infrastructure or growth of the domestic product. Patrick has proposed that the SLA is likely to hold in the early stages of development and at the later stage DFA is more likely. An appropriate link between the financial sector and real sector is required to have a balanced growth and development of a country as well as its regional levels particularly for the countries whose financial developments are not being saturated.

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