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

Abstract

Panel data for 63 countries in 1960-97 reveal no robust relationship between the development of financial intermediaries and the volatility of growth.

Beck, Lundberg, and Majnoni extend the recent literature on the link between financial development and economic volatility by focusing on the channels through which the development of financial intermediaries affects economic volatility. Their theoretical model predicts that well-developed financial intermediaries dampen the effect of real sector shocks on the volatility of growth while magnifying the effect of monetary shocks - suggesting that, overall, financial intermediaries have no unambiguous effect on growth volatility.

The authors test these predictions in a panel data set covering 63 countries over the period 1960-97, using the volatility of terms of trade to proxy for real volatility, and the volatility of inflation to proxy for monetary volatility. They find no robust relationship between the development of financial intermediaries and growth volatility, weak evidence that financial intermediaries dampen the effect of terms of trade volatility, and evidence that financial intermediaries magnify the impact of inflation volatility in low- and middle-income countries.

This paper - a product of Finance, Development Research Group - is part of a larger effort in the group to understand the links between the financial system and economic growth.