1.1. Background of the Study

Financial development plays a crucial role in driving economic growth by facilitating various functions such as financial intermediation, reducing transaction costs, and enabling diversification. It encompasses the effective mobilization of domestic savings for productive investments, which is particularly significant for developing nations in alleviating poverty and fostering economic progress (Levine, 2005; Ellahi, 2011). The development of the financial system is vital for the accumulation of capital, efficient allocation of resources, and technological advancements, all of which are fundamental ingredients for sustained economic growth (Nkoro & Uko, 2013).

The relationship between financial development and economic growth has been a subject of theoretical and empirical analysis. Two opposing theories, namely the supply-leading theory and the demand-following theory, present divergent perspectives on the causal link between financial development and economic growth. The supply-leading theory posits that financial development precedes economic development, as the financial sector supplies the necessary financing for productive investments. In contrast, the demand-following theory argues that economic expansion drives the development of the financial sector, as financing and credit are derived from the demands of the economy (Malarvizhi et al., 2019).

Moreover, the impact of money supply on economic growth is another crucial aspect of financial development. Expansionary monetary policies leading to an increase in the money supply can result in lower interest rates, increased lending and investment, and ultimately, higher gross output and economic growth (Arfanuzzaman, 2014). In this context, the measurement of financial depth, particularly through broad money (M2), becomes significant as it includes the components of narrow money and reflects changes in the overall money supply.

The financial crisis of 2008/2009 demonstrated the critical role of the financial system in the real economy. The United Kingdom, as one of the most highly developed financial systems globally, experienced severe repercussions from the crisis, highlighting the interconnectedness of financial activities with economic performance. The growth of the UK's banking sector and its contribution to the country's gross value added and employment further underscore the importance of a robust financial system for economic vitality (Tyler, 2015; World Bank, 2012).

Additionally, attracting foreign direct investment (FDI) has been a significant policy goal for many developing countries. FDI brings potential benefits such as productivity gains, technology transfers, managerial skills, and access to markets. Identifying factors that impede or induce foreign capital flows into host countries is crucial for policymakers seeking to leverage FDI for economic growth (Aitken & Harrison, 1999; World Bank, 1997a, b).

Cameroon harbors the Bank of Central African States (BEAC), which is the central bank of all the member states of the Economic Community of Central Africa States (CEMAC) to which, Commercial banks, postal banks (CAMPOST), insurance companies, non-banking financial institutions are under the supervision of this central bank (Puatwoe, J. T., & Piabuo, S. M. 2017). The banking sector plays a major role in the financial sector of Cameroon; it accounted for about 84.4% of the total assets of the financial sector in 2005, and contributed 19.6% to GDP, which is still in infancy operates with very limited amount of financial instruments and constitutes mostly of banks as the main arm, with an underdeveloped financial marke. (Puatwoe, J. T., & Piabuo, S. M. 2017).

In Nigeria, the financial sector has grown steadily in recent times, albeit, the socio-economic peculiarities of the country, occasioned by weak institutional quality, poor governance, corruption and insurgency in some parts of the country, among others (Akintola, A. A., Oji-Okoro, I., & Itodo, I. A. 2020).

Also the link between finance and economic growth discussed by many Scholars in Africa in different times. For example Chandang Kurarathe (2001) conclude financial sector development, total private credit extension to GDP and value added ratio were used as a proxy for it, has positive direct effect on per capita GDP or improved financial intermediation and increased liquidity promotes economic growth in South Africa. In the same manner Torroam J.tabor and Chiang(2013) by using stoke of money supply, domestic credits, foreign real credit, inflation and exchange rate as a proxy to financial deepening and applied co- integration and error correction model for the period 1990- 2011 in Nigeria. They conclude the financial sector development has essential role in Nigerian economy.

Murcy et al. (2015) examine the relationship between financial development and economic growth in Kenya using annual time series data. They employed autoregressive distributed lag (ARDL) so as to accommodate small sample data series and to address the problem of endogeneity and found that financial development has a positive and statistically significant effect on economic growth in Kenya in long-run and short-run hence confirmed supply leading hypothesis.Furthermore, Odhiambo (2008) investigated the causality between finance and economic growth in Kenya during 1969-2005 periods. It employed the dynamic multivariate Granger causality test and error correction model. He found that there was only one way causality from economic to finance. The finding indicated that finance act minor role in contribution to economic growth.

Prior to the 1991 reform period, Ethiopia's financial system was governed by the central government, just like that of many other developing nations. In particular, all private banks were nationalized from 1974 until 1991, the duration of the socialist Derg administration. The two government-owned banks, Development Bank of Ethiopia (DBE) and Commercial Bank of Ethiopia (CBE), were the dominating banks during this time (Alemayehu, 2006).

During the years 1981 to 1990, the Commercial Bank of Ethiopia (CBE) was the leading loan provider, sharing 50% (percent) of the total credit, followed by the Development Bank of Ethiopia (DBE) at 40%. The Ethiopian Construction Bank, on the other hand, only covered 10% of the whole credit financial service. The banking and insurance industries were opened to private sector participation by Proclamation No. 84/1994. The declaration signaled the start of a new era in Ethiopia's financial sector, although restricting it to citizens of Ethiopia alone. Private banking and insurance firms proliferated throughout the nation after this declaration (Alemayehu, 2006). Now financial sector consists of about 31 microfinance institutions, 18 insurance firms, and 30 banks with 5311 branches (NBE, 2022/23).

It is evident that both private and public credit has increased throughout the recent period in the country but literature on the relationship and impact of financial depth and Economic growth in Ethiopia is very scant. Therefore, The purpose of this study is to examine the relationship between financial development and economic growth in Ethiopia. Financial development is a multidimensional concept that encompasses the establishment of efficient financial institutions, the deepening of financial markets, and the expansion of financial services. It is widely recognized as a crucial driver of economic growth in both developed and developing countries.

The study aims to investigate the causal relationship between financial depth, measured by indicators such as the size of the banking sector, stock market capitalization, and credit to the private sector, and economic growth in Ethiopia. By analyzing this relationship, the study seeks to provide insights into the specific mechanisms through which financial development influences economic growth in the Ethiopian context.

To conduct this study, a comprehensive dataset covering the relevant financial and economic variables will be collected for the period from 1991 to 2023. The data will include indicators of financial development, such as the ratio of bank credit to GDP, the number of bank branches, and the stock market turnover. Economic growth will be measured by real GDP growth rates.

The study will employ econometric techniques, such as panel data analysis, to estimate the causal relationship between financial development and economic growth. Controlling for other factors that can influence economic growth, such as human capital, infrastructure, and institutional quality, the study will assess the specific impact of financial depth on economic growth in Ethiopia.

The findings of this study are expected to provide valuable insights for policymakers, financial regulators, and other stakeholders in Ethiopia. Understanding the relationship between financial development and economic growth will help inform policy decisions aimed at promoting sustainable and inclusive economic growth in the country. Additionally, the study will contribute to the existing literature on the subject by providing empirical evidence from the Ethiopian context, which has been relatively underexplored in previous studies.