Knowledge Economy and Financial Development in Developing Countries: Evidence from a Panel Autoregressive Distributed-Lag (ARDL) Approach

Using the four World Bank’s Knowledge Economy (KE) pillars, the paper analyses their effect on financial development (FD) in sixteen lower-income, forty-two lower middle-income and thirty-five upper middle-income developing countries. This study covers data from 1996 to 2019 and employs a Pooled Mean Group (PMG) Panel ARDL estimation technique. Empirical results demonstrate that KE pillars (level of education, ICT, innovation landscape and institutional regime) have a positive and significant effect on the long-run financial development in all three income groups. The estimated long run elasticities were highest in the upper middle-income countries, except for the pillar capturing institutional quality. The results are robust we used domestic credit to private sector as a percentage of GDP as an alternative measure of FD and a cross-sectionally augmented autoregressive distributed lag (CS-ARDL) modelling approach that is robust for time dynamics, cross-sectional heterogeneity and cross-sectional dependence. The feedback effects between KE indices and FD are confirmed by the Dumitrescu and Hurlin (Economic Modelling, 29(4), 1450–1460, 2012) Granger Causality test.