Financial deepening and business cycle volatility in Korea

Abstract

This article investigates the role of financial market development on business cycle volatility in the economy of Korea, using time-series data for the period 1967 to 2010. The financial market development and business cycle volatility are measured by three different variables of financial deepening and a moving-average SD of real GDP, respectively. We construct a long-run causality index, as suggested by Granger and Lin (1995), in the context of cointegrated systems and vector error correction model. The estimates indicate that the measures of financial deepening, related to the role of financial institutions, mitigate cyclical fluctuations in the long run, whereas the reverse impacts are rarely evidenced. However, ‘the ratio of M2 to nominal GDP’ as a measure of financial deepening has an intensifying effect on business cycle. Based on the findings, we can infer that financial market reforms will not decrease business cycle volatility quickly.