Financial Distortions and the Distribution of Global Volatility

A generic feature of financial frictions, whatever their origins may be, is to distort the allocation of funds to projects, causing some less productive projects to be funded while more productive projects are not. I formalize this idea by introducing a log supermodularity condition which requires that, at the margin, the difference in productivity between funded and unfunded projects is smaller in more distorted economies. Using this condition, I then revisit the relationship between financial distortions and macroeconomic volatility. My first set of results establish that financial integration shifts the margin of adjustment to global liquidity shocks disproportionately to financially distorted regions, thereby providing a new and simple explanation for the divergent trends in the volatility of emerging and developed economies up to the recent crisis. My second set of results show that a global environment in which liquidity is cheap is conducive to a deterioration of the financial system in the developed world. While cheap liquidity increases and stabilizes output in that region, it amplifies large adverse shocks. JEL Classification: E44, F36, G01, G15