Short-run Gain, Long-run Pain? The Inter-Temporal Trade-Off in the Finance-Volatility Relationship

This paper explores the possibility that financial depth may have a different impact on macroeconomic volatility in the short- versus the long-run. To do so, it employs a panel error-correction model where short- and long-run volatility effects of financial depth are jointly estimated in a sample of 97 countries over the period 1960-2010. Results provide strong evidence that financial depth reduces GDP and investment volatility in the short-run but at the expense of greater volatility in the long-run. Hence there is significant evidence of an inter-temporal tradeoff between financial depth and macroeconomic volatility. Consequently, policymakers must consider both the nature as well as timing of the impact of financial depth on macroeconomic volatility. These findings also reconcile the differing views in related literature on the finance-volatility debate.