Financial Sector Ups and Downs and the Real Sector: Up by the Stairs and Down by the Parachute

This paper examines how financial expansion and contraction cycles affect the broader economy throughtheir impact on eight real economic sectors in a panel of 28 countries over 1960-2005, paying particularattention to large, or sharp, contractions and magnifying and mitigating factors. We find that abruptfinancial contractions are more likely to follow periods of accelerated growth, indicative of ‘up by thestairs, down by the parachute’ dynamics. Sharp fluctuations in the financial sector have asymmetriceffects, with the majority of real sectors adversely affected by contractions but not helped by expansions.The adverse effects of financial contractions are transmitted almost exclusively by the financial opennesschannel with foreign reserves mitigating these effects with a sizeable (10 to 15 times greater) impactduring sharp financial contractions. Both effects are magnified during particularly large financialcontractions (with coefficients on interaction terms two to three times greater than when all contractionsare considered). Consequent upon a financial contraction, the most severe real sector contractions occur incountries with high financial openness; relative predominance of construction, manufacturing, andwholesale and retail sectors; and low international reserves.