Financial development and the magnitude of business cycle volatility

Official URL: http://risc01.sabanciuniv.edu/record=b1606872 (Table of Contents)

This paper empirically analyzes the effect of financial development on business cycle volatility by using panel data from 70 countries for the period between 1990 and 2010. It also studies whether macroeconomic volatility depends on the type of the financial system: market-based versus bank-based. Using a generalized method of moments (GMM) technique, we find that countries with more developed stock markets and banking sectors have less volatility in output, with the stock market development having a more robust effect. We also show that countries with relatively more marketbased financial systems appear to experience more macroeconomic stability. Our empirical results are consistent with the theoretical view that financial development helps to overcome information frictions and corporate governance issues, mitigates shocks more easily, and eases diversification of risks, thereby dampening the amplitude of volatility.