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Financial Intermediary Development and Growth Volatility: Do Intermediaries Dampen or Magnify Shocks?

Do economies with higher levels of financial intermediary development experience more or less volatility in economic growth rates? Do intermediaries dampen the impact of external shocks on the economy or do they amplify them through the credit channel? While the recent empirical and theoretical literature has established a positive impact of financial sector development on economic growth, the potential links between financial development and the volatility of economic growth have not been studied thoroughly yet. Still, the high growth volatility that many developing countries experience has brought to the forefront the question whether and to what extent output fluctuations can be related to the development of the financial sector.

This paper tries to shed light on the links between financial intermediary development and growth volatility both theoretically and empirically. Previous papers have found that financial development reduces macroeconomic volatility (Easterly, Islam, and Stiglitz, 2000; Denizer, Iygun, and Owen, 2000; Gavin and Hausmann, 1995, Raddatz, 2003). However, none of these papers has tried to identify the channels through which financial development potentially affects growth volatility. This paper examines whether financial intermediaries serve as shock absorbers mitigating the effect of real and monetary volatility on growth volatility, or whether they magnify their impact.

Our work is related to three different strands of literature. First, we build on a large empirical literature on the relation between financial development and economic growth. Financial intermediaries and markets emerge to lower the costs of researching potential investments and projects, exerting corporate control, managing risks, and mobilizing savings. Economies with better-developed financial intermediaries and markets therefore enjoy higher growth rates. This literature, however, does not explore the impact of financial development on the volatility of economic growth rates.

A second relevant strand of literature has emphasized the magnifying effect that capital market imperfections have on the propagation of real sector shocks. In particular, Bernanke and Gertler (1990) show that shocks to the net worth of borrowers amplify economic up and downturns, through an accelerator effect on investment.

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Financial Intermediary Development and Growth Volatility: Do Intermediaries Dampen or Magnify Shocks?