Financial Development and Output Volatility: A Cross-Sectional Panel Data Analysis

By Majeed, M. Tariq; Noreen, Ayesha | The Lahore Journal of Economics, January-June 2018 | Go to article overview

Financial Development and Output Volatility: A Cross-Sectional Panel Data Analysis


Majeed, M. Tariq, Noreen, Ayesha, The Lahore Journal of Economics


(ProQuest: ... denotes formulae omitted.)

1.Introduction

Over the past few decades, the concept of output volatility has gained greater attention among economists and policymakers. Figure 1 shows that output volatility does not follow a similar pattern across regions. It has declined over time in East Asia and the Pacific, Latin America and the Caribbean, North America, and the Middle East and North Africa. The reverse is true for Europe and Central Asia, sub-Saharan Africa and South Africa, where no clear pattern of output volatility is observable. Figure 2 shows that countries with higher levels of economic development are less prone to output volatility. Numerous studies show that high output volatility tends to hinder growth and development (see, among others, Bruno & Easterly, 1998; Loayza & Hnatkovska, 2004; Aghion et al., 2004).

There is broad agreement in the literature that high macroeconomic volatility tends to depress investment, is biased toward short-term returns and reduces economic growth (Servén, 2002). Recent work shows that higher macroeconomic volatility is also related to lower investment in human capital (Krebs et al., 2005). High output volatility and financial crises are recurring characteristics of many world economies, but they can be serious obstacles to development because they are closely related to high consumption volatility, high poverty, low long-term growth and high inequality. The literature recognizes that financial sector development has a positive impact on economic growth: a well-functioning financial market enables better relationships between investors and savers, promotes diversification, reduces risk, mitigates information asymmetries, encourages individuals to behave more effectively, and helps stabilize the economy and reduce output volatility (Ramey & Ramey, 1995; Aghion et al., 2000).

In recent years, another important area of research has looked at what causes output volatility and how it can be mitigated. The literature examines different determinants of output volatility, including fiscal policy, consumption volatility, remittances, oil prices and foreign direct investment. While financial development is also a key determinant of output volatility, the literature in this area is not substantial and tends to yield ambiguous results. It is difficult to determine whether financial intermediary development leads to an increase or decrease in output volatility or if it helps reduce the impact of external shocks on the economy.

This paper attempts to identify the possible links between financial intermediary development and output volatility by examining whether financial intermediaries help absorb shocks - thereby reducing the effect of real and monetary volatility - or if they intensify the impact of such shocks. To the best of our knowledge, the relationship between output volatility and financial development has not been extensively researched. Therefore, this paper contributes to the literature by exploring the relationship between financial development and output volatility to determine whether financial development magnifies or reduces the volatility of output.

Additionally, the indicators of financial development used in previous studies do not provide a complete picture of the sector. While most studies have used the ratio of private credit to GDP as a proxy for financial development, this indicator does not include other characteristics such as financial depth, stability, access and efficiency. We use four measures of financial development: (i) the ratio of private credit to GDP (financial depth), (ii) net interest margin (financial efficiency), (iii) z-score (financial stability) and (iv) the number of bank branches per 100,000 adults (financial access). Besides looking at the relationship between financial development and output volatility, we also consider two potential channels through which the sector's development can affect output volatility - real sector volatility and financial sector volatility. …

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