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Volatility and Growth: Credit Constraints and Productivity-Enhancing Investment

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  • Philippe Aghion
  • George-Marios Angeletos
  • Abhijit Banerjee
  • Kalina Manova

Abstract

We examine how credit constraints affect the cyclical behavior of productivity-enhancing investment and thereby volatility and growth. We first develop a simple growth model where firms engage in two types of investment: a short-term one and a long-term productivity-enhancing one. Because it takes longer to complete, long-term investment has a relatively less procyclical return but also a higher liquidity risk. Under complete financial markets, long-term investment is countercyclical, thus mitigating volatility. But when firms face tight credit constraints, long-term investment turns procyclical, thus amplifying volatility. Tighter credit therefore leads to both higher aggregate volatility and lower mean growth for a given total investment rate. We next confront the model with a panel of countries over the period 1960-2000 and find that a lower degree of financial development predicts a higher sensitivity of both the composition of investment and mean growth to exogenous shocks, as well as a stronger negative effect of volatility on growth.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 11349.

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Date of creation: May 2005
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Handle: RePEc:nbr:nberwo:11349

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