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The Effects of Volatility on Growth and Financial Development through Capital Market Imperfections

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  • Aysan, Ahmet Faruk

Abstract

This paper provides a model to account for the empirical evidence that volatility reduces growth. In the model, greater volatility increases the cost associated with capital market imperfections and induces the financial intermediaries to charge higher interest rates. The model is based on one of overlapping generations with two types of technologies. The more productive technology requires fixed investment in the first period. Individual with income less than the amount of fixed investment may borrow in financial markets to obtain more productive technology. Increase in volatility raises the cost of borrowing and makes it less attractive to invest in more productive technology for individuals below certain income in the first period. Hence, volatility reduces growth by deterring people from taking advantage of more productive technology. This model also explains the empirical findings of Ramey and Ramey (1995) that investment is not the channel between volatility and growth by suggesting that totals factor productivity rather than the total factor accumulation is the key for growth.

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Bibliographic Info

Paper provided by University Library of Munich, Germany in its series MPRA Paper with number 5486.

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Date of creation: 2006
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Handle: RePEc:pra:mprapa:5486

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Keywords: Volatility; Growth; Financial Development; Capital Market Imperfections; Costly State Verification; Limited Enforceability of Contracts;

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  1. Romain Ranciere & Aaron Tornell & Frank Westermann, 2004. "Crises and Growth: A Re-evaluation," UCLA Economics Working Papers 832, UCLA Department of Economics.
  2. Robert S. Pindyck & Andrés Solimano, 1993. "Economic Instability and Aggregate Investment," NBER Chapters, in: NBER Macroeconomics Annual 1993, Volume 8, pages 259-318 National Bureau of Economic Research, Inc.
  3. Kormendi, Roger C. & Meguire, Philip G., 1985. "Macroeconomic determinants of growth: Cross-country evidence," Journal of Monetary Economics, Elsevier, vol. 16(2), pages 141-163, September.
  4. Joshua Aizenman & Nancy Marion, 1991. "Policy Uncertainty, Persistence and Growth," NBER Working Papers 3848, National Bureau of Economic Research, Inc.
  5. Martin, Philippe & Ann Rogers, Carol, 2000. "Long-term growth and short-term economic instability," European Economic Review, Elsevier, vol. 44(2), pages 359-381, February.
  6. Bernanke, Ben & Gertler, Mark, 1989. "Agency Costs, Net Worth, and Business Fluctuations," American Economic Review, American Economic Association, vol. 79(1), pages 14-31, March.
  7. Robert Townsend, 1979. "Optimal contracts and competitive markets with costly state verification," Staff Report 45, Federal Reserve Bank of Minneapolis.
  8. Garey Ramey & Valerie A. Ramey, 1994. "Cross-Country Evidence on the Link Between Volatility and Growth," NBER Working Papers 4959, National Bureau of Economic Research, Inc.
  9. Pritchett, Lant, 2000. "Understanding Patterns of Economic Growth: Searching for Hills among Plateaus, Mountains, and Plains," World Bank Economic Review, World Bank Group, vol. 14(2), pages 221-50, May.
  10. Aizenman, Joshua & Powell, Andrew, 2003. "Volatility and financial intermediation," Journal of International Money and Finance, Elsevier, vol. 22(5), pages 657-679, October.
  11. Aizenman, Joshua & Marion, Nancy, 1999. "Volatility and Investment: Interpreting Evidence from Developing Countries," Economica, London School of Economics and Political Science, vol. 66(262), pages 157-79, May.
  12. Betancourt, Roger R, 1996. "Growth Capabilities and Development: Implications for Transition Processes in Cuba," Economic Development and Cultural Change, University of Chicago Press, vol. 44(2), pages 315-31, January.
  13. Grier, Kevin B. & Tullock, Gordon, 1989. "An empirical analysis of cross-national economic growth, 1951-1980," Journal of Monetary Economics, Elsevier, vol. 24(2), pages 259-276, September.
  14. Erik Canton, 2002. "Business cycles in a two-sector model of endogenous growth," Economic Theory, Springer, vol. 19(3), pages 477-492.
  15. Levine, Ross & Renelt, David, 1992. "A Sensitivity Analysis of Cross-Country Growth Regressions," American Economic Review, American Economic Association, vol. 82(4), pages 942-63, September.
  16. Ahmed Mushfiq Mobarak, 2005. "Democracy, Volatility, and Economic Development," The Review of Economics and Statistics, MIT Press, vol. 87(2), pages 348-361, May.
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Cited by:
  1. Anis Chowdhury, 2012. "Structural Adjustment and Crises –Which Way Now?," Institutions and Economies (formerly known as International Journal of Institutions and Economies), Faculty of Economics and Administration, University of Malaya, vol. 4(1), pages 85-118, April.

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