Investigating Financial Conditions As Key Determinants Of Growth Differentials In The Euro Area

The financial crisis highlights the need to incorporate financial linkages into macro-econometric models.Financial conditions are important to central banks,because monetary policy tends to influence the economy by its effect on the financial markets.This master thesis investigates the influence of financial conditions on economic growth in the Euro Area.The central question is:Could financial conditions,combined into a new index,explain the economic growth differentials between European countries?The most important contribution is collecting and setting up the financial conditions index(FCI)for a panel of European countries.To construct the indices,I apply Principal component analysis on a panel of financial variables.In order to answer the research question,I conduct panel data analysis in which I include the FCI as an explanatory variable while controlling for other growth variables.To test if the FCI significantly differs across European countries,I apply the Welch's ANOVA test.The results reveal that the FCI significantly explains GDP growth rates.I illustrate that the FCI tracks output growth consistently basing on historical events.Contrary to my expectations,the FCIs difference between European countries resulted insignificant.Running a second growth regression on a different panel of FCIs,as well as applying a lagged model,gives evidence to support the claim that the FCI can be seen as a key determinant of economic growth.