Financial development and declining growth volatility: Explanations and an empirical study with the latest FD index.

• We find that financial development reduces growth variability across various horizons, with some signs of heterogeneity and nonlinearity. • Since Burns (1960) many authors drew attention to a trend that macroeconomic volatility has been declining at least from the WW2 and mid-eighties both in US and other countries. • Like some authors, we found evidence of a non-linear relationship (decreasing marginal effect) , although not in every specification and horizon. • Fluctuations in world economic growth have been the most consistent factor amplifying growth fluctuations in individual countries, while institutional development has had a significant dampening effect. • Although there is no single identifiable date for any individual or collective moderation, data from our sample suggest that both average volatility in each period and volatility in most individual economies have been decreasing for at least 40 years. • Estimates of the main equation using five-year data with various specifications show that financial development is significantly associated with decreasing volatility at the relevant p values (Table 3, regression 1 (R1) to regression 8 (R8). • From this level, the financial development index begins to increase growth volatility instead of decreasing it. • On the contrary, the relationship is stronger with a larger coefficient and linearity in reducing volatility. • We find that there is a strong theoretical literature that suggests alternative causes and channels to explain how financial development can help reduce volatility. • As expected from nonlinearity, marginal effects were stronger when we excluded high-income (eurozone) economies. Growth is liked, but volatility is not. Volatility implies uncertainty, as up and down are often large unpredictable fluctuations. In fact, according to the financial literature, people pay a price to reduce it. Some studies found a trend that macroeconomic volatility has been changing and proposed some structural changes that are responsible for its decline. Many studies have found that financial development helps growth. And relatively few studies have shown that financial development also explains structurally varying macroeconomic volatility. In this panel study, we investigated the relationship between financial development and growth volatility using the Financial Development Index with recent data from eighty-six countries. We also looked at its relationship with consumption and investment fluctuations using its sub-indices. The index is the result of many dimensions of financial development such as access and efficiency, not just the size of credit. We find that financial development reduces growth variability across various horizons, with some signs of heterogeneity and nonlinearity. Institutional development (polity index) and volatility in global economic growth are other important consistent variables. [ABSTRACT FROM AUTHOR]