The Bounds Test Approach for Cointegration and Causality between Financial Development, International Trade and Economic Growth: The Case of Cyprus

This study employs the bounds test for co-integration and Granger causality tests to investigate the long-run equilibrium relationship between financial development, international trade and real income growth. Furthermore we are intersting in finding the direction of causality among these economic variablesfor the Cyprus economy. The results of the study reveal that financial development as measured by broad money (M2), international trade and real income growth are co-integrated; thus, a long-run equilibrium relationship can be inferred for these three variables. On the other hand, Granger causality test results suggest that in Cyprus the growth in real income stimulates the growth of international trade (both exports and imports) and the money supply. Furthermore, growth in imports of goods and services also stimulates an increase in exports of goods and services of Cyprus. Although this result contradicts our initial expectations it indicates the importance of capital inflows in Cyprus that played a major role in financing the investments mainly in the tourism sector. Thus, results of this study reveal that the supply-leading, export-led growth, and import-led growth hypotheses are not confirmed by this study whereas the demand-following hypothesis can be justified for the Cypriot economy when M2 measure of money supply is under consideration.