The effects of the informal economy on the relationship between financial development and economic growth

Abstract

The relationship between economic growth and the development of financial systems has been analyzed from different perspectives for a long time. This paper addresses the effects of the informal economy on the relationship between financial development and economic growth, using a panel data covering 20 countries during the period 1993–2020. The results show that financial development, as measured by the IMF’s Financial Development Index, is positively associated with economic growth (the coefficient α1 related to financial development fd is positive and statistically significant at 5%). The results also show that large sizes of the informal economy moderate the influence of this association (α1 remains positive and statistically significant at 1%, while the coefficient α2 related to the interaction between financial development and informal economy, fd and ie, is negative and statistically significant at 1%). In effect, financial development has the greatest impact on economic growth whenever there is control over the informal economy’s size. Inversely, a favorable ground for the informal economy limits the positive association between financial development and economic growth. However, the results show the absence of a causality relationship between financial development and economic growth (W-bar = 1.0015 and Z-bar = 0.0048; p-value = 0.9980). The informal economy plays no role in making this type of link significant (W-bar = 0.9761 and Z-bar = -0.0756; p-value = 0.9520).