Financial Development and Long-Run Volatility Trends

Countries with more developed …nancial markets (as measured by the private debtto-GDP ratio) tend to have signi…cantly lower aggregate volatility. This relationship is also highly non-linear— starting from a low level of …nancial development the reduction in aggregate volatility by …nancial deepening is far more signi…cant than it is when the …nancial market is more developed. We build a fully-‡edged neoclassical growth model with an endogenous …nancial market of credit arrangements and private debt to rationalize these stylized facts. We show how …nancial development that promotes better credit allocations under more relaxed borrowing constraints can reduce the impact of non-…nancial shocks (such as TFP shocks, government spending shocks, preference shocks) on aggregate output and investment, and why this volatility-reducing e¤ect diminishes with continuing …nancial development. 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 …rms. Keywords: Financial Development, Firm Dynamics, Private Debts, Volatility Trends, Great Moderation, Lumpy Investment. JEL codes: D21, D58, E22, E32. This paper was circulated originally with the title "Financial Development and Economic Volatility: A Uni…ed Explanation." We thank Steven Davis and seminar participants at numerous institutions for comments on an earlier version of the paper, Mingyu Chen for research assistance, and Judy Ahlers for editorial assistance. Pengfei Wang acknowledges the …nancial support of the Hong Kong Research Grants Council (project #643908). The usual disclaimer applies. Pengfei Wang, Department of Economics, Hong Kong University of Science & Technology (e-mail: [email protected]). Yi Wen, Research Department, Federal Reserve Bank of St. Louis (e-mail: [email protected]); School of Economics and Management, Tsinghua University, Beijing, China.