Good volatility vs. bad volatility: The asymmetric impact of financial depth on macroeconomic volatility

Abstract

AbstractThis paper explores the possibility that financial depth may have an asymmetric impact on macroeconomic volatility by affecting its “good” and “bad” components in different ways. While “good” volatility refers to positive shocks to gross domestic product, consumption and investment growth, “bad” volatility denotes negative fluctuations in these macroeconomic indicators. Dynamic panel regressions in a sample of 97 countries over the period 1960–2010 provide evidence of asymmetry on three main grounds. First, financial depth reduces good volatility but does not have much impact on bad volatility except that it reduces some bad volatility of consumption. Second, though financial depth reduces both good and bad volatility of consumption, the reduction in the good component is much greater. Third, the impact of financial depth on macroeconomic volatility varies across sectors. Particularly in low‐income economies, financial depth enables better consumption decisions but poorer investment choices. These results have important policy implications.