In order to apply the Johansen proc

In order to apply the Johansen procedure, Lag length is selected on the basis
of the Akaike Information Criterion (AIC).
If co-integration in the l
ong run is
present then the system of equations is
restructured by inserting an Error Correction Term
to capture the short-run deviation
of variables from their relevant equilibri
um values. This investigation is necessary
as impact of financial development is gene
rally more apparent in the short-run and
disappears in the long run as economy expands
and matures. According to Granger
(1988) presence of cointegrating vectors indicates that granger causality must exist
in at least one direction. A variable granger causes the other variable if it helps
forecast its future values. In cointegrated
series, as variables may possibly share
common stochastic trends so dependent va
riables in the VECM must be Granger-
caused by lagged values of the error-correc
tion terms. This is possible because error-
correction terms are functions of the lagged
values of the level variables. Thus an
evidence of cointegration between variabl
es itself provides the basis for construction
of error correction model. ECM permits
the introduction of past disequilibrium as