Volatility and Growth: Financial Development and the Cyclical Composition of Investment ∗

Abstract

This paper investigates how financial development affects the cyclical behavior of the composition of investment and thereby volatility and growth. We first consider an endogenous growth model in which firms engage in two types of investment, a short-term investment activity (physical capital) and a long-term growth-enhancing one (R&D). Under complete financial markets, R&D tends to be countercyclical, thus mitigating volatility, and mean growth tends to increase with volatility. These relations are reversed when firms face tight borrowing constraints: R&D becomes procyclical, thus amplifying volatility, and mean growth tends to decrease with volatility. Moreover, the tighter the credit constraints, the higher the sensitivity of R&D and growth to exogenous shocks. We next confront the model with cross-country data over the period 19602000. We find that a lower degree of financial development predicts a more negative relation between growth and volatility, a higher sensitivity of growth to shocks, and a more countercyclical R&D over total investment.

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