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Financial development and long-run volatility trends

Listed author(s):
  • Wang, Pengfei

    ()

    (Hong Kong University of Science & Technology)

  • Wen, Yi

    ()

    (Federal Reserve Bank of St. Louis)

  • Xu, Zhiwei

    ()

    (Shanghai Jiao Tong University)

Countries with more developed financial markets tend to have significantly lower aggregate volatility. This relationship is also highly non-linear starting from a low level of financial development the reduction in aggregate volatility is far more significant with respect to financial deepening than when the financial market is more developed. We build a fully-edged heterogeneous-agent model with an endogenous financial market of private credit and debt to rationalize these stylized facts. We show how financial development that promotes better credit allocations under more relaxed borrowing constraints can reduce the impact of non-financial shocks (such as TFP shocks, government spending shocks, preference shocks) on aggregate output and investment, and why this volatility-reducing effect diminishes with continuing financial liberalizations. Our simple model also sheds light on a number of other important issues, such as the "Great Moderation" and the simultaneously rising trends of dispersions in sales growth and stock returns for publicly traded firms.

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File URL: http://research.stlouisfed.org/wp/2013/2013-003.pdf
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File URL: https://doi.org/10.20955/wp.2013.003
File Function: https://doi.org/10.20955/wp.2013.003
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Paper provided by Federal Reserve Bank of St. Louis in its series Working Papers with number 2013-003.

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Length: 57 pages
Date of creation: 2013
Date of revision: 18 Aug 2017
Handle: RePEc:fip:fedlwp:2013-003
DOI: 10.20955/wp.2013.003
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