Financial Development, Shocks, and Growth Volatility

In this paper, we argue that study of the effect of financial development and shocks on aggregate growth volatility will not be informative because they affect growth volatility through its different components. Financial development affects only the business cycle component of volatility and therefore, the effect on total volatility is dependent on its share in total volatility. On the contrary, shocks affect total volatility through its both long run and business cycle components. We use spectral method to extract different components of growth volatility. Empirical evidence provides qualified support for both hypotheses. Higher private credit, which is used as proxy of financial development, dampens business cycle volatility but not the long run component of volatility. Shocks as measured by changes in the terms of trade affect both business cycle and long run components of volatility negatively. These results are robust to alternative market-based measure of financial development, and corrections for reverse causality. JEL Classification codes: C21, C22, E32, E44, O16, O50