Revisiting the Link Between Finance and Macroeconomic Volatility
IMF Working Papers, January 30, 2013
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Bibliographic details
- Authors: Era Dabla-Norris, Narapong Srivisal
- Published: January 30, 2013
- Series: IMF Working Papers
- DOI: https://doi.org/10.5089/9781475543988.001
Summary findings
- The paper examines the impact of financial depth on macroeconomic volatility using a dynamic panel analysis for 110 advanced and developing countries.
- Financial depth plays a significant role in dampening the volatility of output, consumption, and investment growth, but only up to a certain point.
- At very high levels of financial depth, such as those observed in many advanced economies, financial depth amplifies consumption and investment volatility.
- Deeper financial systems serve as shock absorbers, mitigating the negative effects of real external shocks on macroeconomic volatility.
- The smoothing effect is particularly pronounced for consumption volatility in environments of high exposure—when trade and financial openness are high—suggesting significant gains from further financial deepening in developing countries.
Evidence on thresholds and nonlinear effects
- Financial depth reduces volatility for output, consumption, and investment growth up to a threshold; beyond that threshold, financial depth amplifies consumption and investment volatility.
- Very high levels of financial depth are associated with amplification (rather than attenuation) of consumption and investment volatility in many advanced economies.
Shock absorption and openness
- Strong evidence that deeper financial systems mitigate the negative effects of real external shocks on macroeconomic volatility.
- The mitigation (smoothing) effect is especially strong for consumption volatility when exposure is high (high trade and financial openness).
- Findings imply potential welfare gains from further financial deepening in developing countries exposed to external shocks.
Policy implications and interpretation
- Financial deepening can reduce macroeconomic volatility, but benefits are nonlinear and may reverse at very high depth levels.
- Policymakers in developing countries with lower or moderate financial depth can expect significant volatility-reducing gains from further financial development.
- Advanced economies with very deep financial systems should recognize potential risks of increased consumption and investment volatility associated with further deepening.