Financial Development and Economic Volatility: A Unified Explanation

Empirical studies showed that …rm-level volatility has been increasing but the aggregate volatility has been decreasing in the US for the post-war period. This paper proposes a uni…ed explanation for these diverging trends. Our explanation is based on a story of …nancial development –measured by the reduction of borrowing constraints because of greater access to external …nancing and options for risk sharing. By constructing a dynamic stochastic general-equilibrium model of heterogenous …rms facing borrowing constraints and investment irreversibility, it is shown that …nancial liberalization increases the lumpiness of …rm-level investment but decreases the variance of aggregate output. Hence, the model predicts that …nancial development leads to a larger …rm-level volatility but a lower aggregate volatility. In addition, our model is also consistent with the observed decline in volatility of private held …rms which do not have (or have only limited) access to external funds.