By employing a battery of time-series techniques, the paper empirically examines the short- and long-run finance-growth nexus during the post-1997 financial turmoil in Malaysia and Indonesia. Based on the Autoregressive Distributed Lag (ARDL) models, the study documents a long-run equilibrium between economic growth, finance depth and inflation. Granger causality tests based on the Vector Error Correction Model (VECM) further reveal that there are: (1) No causality between finance and growth in Indonesia, which accords with the independent hypothesis of Lucas (1988); and (2) A unidirectional causality running from finance to growth in Malaysia, thus supporting the finance-growth led hypothesis or the supply-leading view. Based on the Impulse-Response Functions (IRFs), the study discovers that the variations in the economic growth rely very much on economic innovations.

The economies of Malaysia and Indonesia have remarkably recovered post-1997 financial turmoil. The International Monetary Fund (IMF) Report (2006) reveals that Malaysian and Indonesian economies grew by 5.9% and 5.6% respectively. Malaysia's growth rate was above the Association of Southeast Asian Nations (ASEAN) average growth of 5.8%, while that of Indonesia was below the regional average. Compared to the growth rates of larger emerging economies, such as India and China, those of Malaysia and Indonesia are slightly higher (Mussa, 2006). Numerous researchers have examined the reason for the countries' differing economic growth rates since the early 1930s. The literature on economic growth has come up with numerous explanations for cross-country differences in growth, including the degree of macroeconomic stability, international trade, resource endowments, legal system effectiveness, religious diversity and educational attainment. The list of likely factors continues to expand, apparently without limit (Khan and Senhadji, 2000).

Of these possible factors contributing to economic growth, the role played by the financial sector has begun to receive attention recently, though recognition of a significant relationship between financial development and economic growth dates back to the Theory of Economic Development by Schumpeter (1911). However, the question of whether financial development preceded economic growth or vice versa has been debated in the finance literature. The pioneering studies in this area—such as those by Goldsmith (1969), McKinnon (1973) and Shaw (1973)—have documented positive relationships between financial development and economic growth. Robinson (1952) found that financial development follows economic growth. Lucas (1988) argued that financial development and economic growth are independent and not causally related. Finally, Demetriades and Hussein (1996) and Greenwood and Smith (1997) postulated that the two variables are mutually causal, i.e., they have a bidirectional causality.

Applied Finance Journal, Vector Error Correction Model, Autoregressive Distributed Lag, Economic Innovations, International Monetary Fund, IMF, Economic Growth, Financial Development, Financial Sectors, Economic Development, Economic Sectors, Financial Crisis, Gross Domestic Product, GDP.