Institutional Quality as a Determinant of the Finance–Growth Relationship: Evidence from Developing and Middle-Income Nations

Abstract

This article investigates the interaction between economic growth and financial development in emerging and middle-income nations from 2000 to 2023 with a focus on the moderating role of institutional quality. Using panel data from the World Development Indicators, the IMF Financial Development Database, and the Worldwide Governance Indicators, the article examines the ways in which institutional strength mediates the growth benefit from financial development. The empirical analysis follows several stages: the Pedroni and Kao cointegration tests confirm the presence of a stable long-run interaction among the variables; the Pesaran–Yamagata (2008) test confirms slope heterogeneity; and unit root and cross-sectional dependency tests record mixed orders of integration and cross-country dependencies. The Cross-Sectionally Augmented Autoregressive Distributed Lag (CS-ARDL) estimates present that the institutional quality and the financial development exhibit significant and positive impacts in the long term on economic growth. In addition, the interaction effect between the two variables emphasizes the significance of well-performing institutional conditions in facilitating the growth effect from the growth in the financial sector. Conversely, trade openness only yields a weak positive effect, and inflation adversely influences growth. Overall, the estimates provide substantial policy directions for emerging and middle-income nations with the objective of creating inclusive, stable, and sustainable growth, with specific significance targeting the role of good institutions in efficient mobilization of the financial resources towards sustained economic growth.