Financial Development and Long-Run Volatility Trends

Abstract

Countries with more developed financial markets (as measured by the private debt-to-GDP ratio) 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 by financial deepening is far more significant than it is when the financial market is more developed. We build a fully-‡edged neoclassical growth model with an endogenous financial market of credit arrangements and private 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 development. 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.