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Financial development, shocks, and growth volatility
This paper uses spectral theory to develop the following two testable hypotheses in a unified framework for the predictions of business-cycle and endogenous growth models: (i) financial development affects only business-cycle volatility; and (ii) shocks affect both business-cycle volatility and long-run volatility of GDP growth. In other words, volatility caused by shocks is more persistent than that caused by financial underdevelopment. We decompose the business-cycle and long-run volatility by the spectral method and then test the hypotheses at the cross-country level. Empirical evidence provides support for both hypotheses. Higher private credit, a bank-based measure of financial development, dampens business-cycle volatility but not long-run volatility. Volatility of shocks, as measured by the volatility of changes in the terms of trade, magnifies both business-cycle and long-run volatility. The results are robust to accounting for endogeneity, a market-based measure of financial development, and an alternative method of volatility decomposition.
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Journal
Macroeconomic dynamicsVolume
18Issue
3Pagination
651 - 688Publisher
Cambridge University PressLocation
Cambridge, EnglandPublisher DOI
ISSN
1365-1005eISSN
1469-8056Language
engPublication classification
C1 Refereed article in a scholarly journalUsage metrics
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