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Financial Volatility and Economic Activity

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  • Fabio Fornari
  • Antonio Mele

Abstract

Does uncertainty in capital markets affect the business cycle? We find that financial volatility predicts 30% of post-war economic activity in the United States, and that during the Great Moderation, aggregate stock market volatility explains, alone, up to 55% of real growth. In out-of-sample tests, stock price volatility helps predict turning points over and above traditional financial variables such as creditor term spreads, and other leading indicators. Combining stock volatility and the term spread leads to a proxy for (i) aggregate risk, (ii) risk-premiums and (iii) a gauge of monetary policy conduct, which tracks and anticipates the business cycle. At the heart of our analysis is a notion of volatility based on a slowly changing measure of return variability. This volatility is designed to capture long-run uncertainty in capital markets, and is particularly successful at explaining trends in the economic activity at horizons of six months and one year.

Suggested Citation

  • Fabio Fornari & Antonio Mele, 2013. "Financial Volatility and Economic Activity," Journal of Financial Management, Markets and Institutions, Società editrice il Mulino, issue 2, pages 155-198, December.
  • Handle: RePEc:mul:jdp901:doi:10.12831/75569:y:2013:i:2:p:155-198
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    More about this item

    Keywords

    Capital Markets Uncertainty; Asset Prices and the Business Cycle; Macroeconomic Risk; Volatility Spillovers; the Great Moderation;
    All these keywords.

    JEL classification:

    • G00 - Financial Economics - - General - - - General
    • N12 - Economic History - - Macroeconomics and Monetary Economics; Industrial Structure; Growth; Fluctuations - - - U.S.; Canada: 1913-

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