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Financial Development And Economic Volatility: A Unified Explanation

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Executive Summary

Empirical studies showed that firm-level volatility has been increasing but the aggregate volatility has been decreasing in the US for the post-war period. This paper proposes a unified explanation for these diverging trends. The authors' explanation is based on a story of financial development - measured by the reduction of borrowing constraints because of greater access to external financing and options for risk sharing. By constructing a dynamic stochastic general-equilibrium model of heterogenous firms facing borrowing constraints and investment irreversibility, it is shown that financial liberalization increases the lumpiness of firm-level investment but decreases the variance of aggregate output.

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