Financial development and economic volatility: a unified explanation

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. Our 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. Hence, the model predicts that financial development leads to a larger firm-level volatility but a lower aggregate volatility. In addition, our model is also consistent with the observed decline in volatility of private held firms which do not have (or have only limited) access to external funds.