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Federal Reserve Bank of St. Louis
Working Papers
Financial development and long-run volatility trends
Pengfei Wang
Yi Wen
Zhiwei Xu

Countries with more developed financial markets tend to have significantly lower aggregate volatility. This relationship is also highly non-linear starting from a low level of financial development the reduction in aggregate volatility is far more significant with respect to financial deepening than when the financial market is more developed. We build a fully-edged heterogeneous-agent model with an endogenous financial market of private credit and debt to rationalize these stylized facts. We show how financial development that promotes better credit allocations under more relaxed borrowing constraints can reduce the impact of non-financial shocks (such as TFP shocks, government spending shocks, preference shocks) on aggregate output and investment, and why this volatility-reducing effect diminishes with continuing financial liberalizations. Our simple model also sheds light on a number of other important issues, such as the "Great Moderation" and the simultaneously rising trends of dispersions in sales growth and stock returns for publicly traded firms.

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Pengfei Wang & Yi Wen & Zhiwei Xu, Financial development and long-run volatility trends, Federal Reserve Bank of St. Louis, Working Papers 2013-003, 2013, revised 18 Aug 2017.
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Keywords: Financial Development; Firm Dynamics; Private Debts; Volatility Trends; Great Moderation; Lumpy Investment
DOI: 10.20955/wp.2013.003
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