Financial development and long-run volatility trends

Abstract

Countries with more developed financial markets tend to have significantly lower aggregate volatility. This relationship is also highly non-linear—starting from a low level of financial development the reduction in aggregate volatility is far more significant with respect to financial deepening than when the financial market is more developed. We build a fully-fledged heterogeneous-agent model with an endogenous financial market of private credit and debt to rationalize these stylized facts. We show how financial development that promotes better credit allocations under more relaxed borrowing constraints can reduce the impact of non-financial shocks (such as TFP shocks, government spending shocks, preference shocks) on aggregate output and investment, and why this volatility-reducing effect diminishes with continuing financial liberalizations. Our simple model also sheds light on a number of other important issues, such as the “Great Moderation” and the simultaneously rising trends of dispersions in sales growth and stock returns for publicly traded firms.