The Effects of Expected and Unexpected Volatility on Long-Run Growth: Evidence from 18 Developed Economies

Abstract

1. IntroductionAlthough there is disagreement about the magnitude, many economists agree that business cycles have negative consequences for welfare in the short run by causing output to deviate from potential. As a result, most policymakers regard reducing volatility as a desirable goal. However, there is disagreement about the long-run consequences of business cycles.Some models suggest that business cycle volatility should reduce long-run growth. In these models, increased volatility increases risk, reduces investment, and slows the growth rate of output. In addition, volatility may reduce the diffusion rate of new technology, which might reduce the long-run growth rate. Hence, business cycles have negative short-run consequences (by causing output to deviate from the trend) and negative long-run consequences (by slowing the long-run growth rate). If these models are accurate, then the welfare consequences of business cycles are more severe than previously thought.An alternative view of the growth-volatility relationship suggests that there may be a long-run benefit to business cycles. In these models, increased volatility stimulates inventive activity, which increases the long-run growth rate. Reduced volatility will be beneficial in the short run, but if reduced volatility decreases the long-run growth rate, then there are costs to stabilization. As a result, policymakers would face a trade-off between business cycle volatility and long-run growth. In addition, it is possible that the long-run costs of stabilization policy might exceed the short-run benefits.This article sheds new light on the growth-volatility relationship. First, this article focuses on two types of volatility: expected volatility and unexpected volatility. This allows a more thorough test of the two general hypotheses linking growth to volatility. Second, this article empirically examines the relationship between growth and volatility for 18 industrialized nations over a 110-year period. Therefore, the analysis avoids the problem of short time span of data.This article proceeds as follows. Section 2 clarifies the relationship between the competing hypotheses as well as between expected and unexpected volatility. Section 3 analyzes the growth-volatility relationship without making the distinction between expected and unexpected volatility. Section 4 uses generalized method of moments (GMM) and ordinary least squares (OLS) along with panel data to estimate the effects of expected and unexpected volatility on growth. Section 5 concludes with suggestions for further research.2. The Growth-Volatility RelationshipThe view that business cycle volatility reduces the long-run growth rate focuses on risk. Bernanke (1983), Ramey and Ramey (1991), and Pindyck (1991) argue that volatility creates risk about future demand and that firms are unlikely to invest in new plants and equipment if they are unsure about the demand for their product. The greater the volatility in output, the more uncertain future demand becomes; the greater the risk, and the less likely firms are to invest. This negative relationship between volatility and investment might lead to a negative relationship between growth and volatility: Increased volatility decreases investment, which then slows the growth rates of the capital stock and output. The effect would be especially pronounced if new technology is embodied in new capital goods. Ramey and Ramey (1995) and Macri and Sinha (2000) have found results consistent with this view of the growth-volatility relationship using aggregate data. This view emphasizes the risks associated with unexpected changes in output: When firms cannot accurately forecast the demand for their goods, they reduce capital expenditures, which reduces growth.The view that business cycles might increase long-run growth focuses on the opportunity cost of productivity-enhancing activities (PEAs). Bean (1990) and Saint-Paul (1993) view firms as solving an intertemporal profit-maximizing problem in which producing goods provides profits today but engaging in PEAs produces profits only in the distant future. …