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Financial development and economic volatility: a unified explanation

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  • Pengfei Wang
  • Yi Wen

Abstract

Empirical studies showed that firm-level volatility has been increasing but the aggregate volatility has been decreasing in the US for the post-war period. This paper proposes a unified explanation for these diverging trends. Our explanation is based on a story of financial development - measured by the reduction of borrowing constraints because of greater access to external financing and options for risk sharing. By constructing a dynamic stochastic general-equilibrium model of heterogenous firms facing borrowing constraints and investment irreversibility, it is shown that financial liberalization increases the lumpiness of firm-level investment but decreases the variance of aggregate output. Hence, the model predicts that financial development leads to a larger firm-level volatility but a lower aggregate volatility. In addition, our model is also consistent with the observed decline in volatility of private held firms which do not have (or have only limited) access to external funds.

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Bibliographic Info

Paper provided by Federal Reserve Bank of St. Louis in its series Working Papers with number 2009-022.

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Date of creation: 2009
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Handle: RePEc:fip:fedlwp:2009-022

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Keywords: Financial institutions ; Business cycles;

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  1. Zvi Hercowitz & Jeffrey C. Campbell, 2005. "The Role of Collateralized Household Debt in Macroeconomic Stabilization," 2005 Meeting Papers 120, Society for Economic Dynamics.
  2. Clarida, Richard & Galí, Jordi & Gertler, Mark, 1998. "Monetary Policy Rules and Macroeconomic Stability: Evidence and Some Theory," CEPR Discussion Papers 1908, C.E.P.R. Discussion Papers.
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  4. Jeremy Greenwood & Juan M. Sanchez & Cheng Wang, 2007. "Financing Development: The Role of Information Costs," NBER Working Papers 13104, National Bureau of Economic Research, Inc.
  5. Urban Jermann & Vincenzo Quadrini, 2006. "Financial Innovations and Macroeconomic Volatility," NBER Working Papers 12308, National Bureau of Economic Research, Inc.
  6. Thomas Philippon & Fatih Guvenen, 2005. "Firm Volatility and Wage Inequality," 2005 Meeting Papers 230, Society for Economic Dynamics.
  7. Per Krusell & Anthony A. Smith, Jr., . "Income and Wealth Heterogeneity in the Macroeconomy," GSIA Working Papers 1997-37, Carnegie Mellon University, Tepper School of Business.
  8. James H. Stock & Mark W. Watson, 2002. "Has the Business Cycle Changed and Why?," NBER Working Papers 9127, National Bureau of Economic Research, Inc.
  9. Leo Kaas, 2009. "Firm volatility and credit: a macroeconomic analysis," Review, Federal Reserve Bank of St. Louis, issue Mar, pages 95-106.
  10. Jianjun Miao, 2003. "Optimal Capital Structure and Industry Dynamics," Industrial Organization 0310001, EconWPA.
  11. Dynan, Karen E. & Elmendorf, Douglas W. & Sichel, Daniel E., 2006. "Can financial innovation help to explain the reduced volatility of economic activity?," Journal of Monetary Economics, Elsevier, vol. 53(1), pages 123-150, January.
  12. Paul J. Irvine & Jeffrey Pontiff, 2009. "Idiosyncratic Return Volatility, Cash Flows, and Product Market Competition," Review of Financial Studies, Society for Financial Studies, vol. 22(3), pages 1149-1177, March.
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Cited by:
  1. Yi Wen, 2013. "Evaluating unconventional monetary policies -why aren’t they more effective?," Working Papers 2013-028, Federal Reserve Bank of St. Louis.
  2. Miao, Jianjun & Wang, Pengfei, 2009. "Does Lumy Investment Matter for Business Cycles?," MPRA Paper 14977, University Library of Munich, Germany.
  3. Yang Jiao & Yi Wen, 2012. "Capital, finance, and trade collapse," Working Papers 2012-003, Federal Reserve Bank of St. Louis.

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