The Impact of Macroeconomic Volatility on Economic Growth

The aim of the paper is to assess the impact of macroeconomic volatility on economic growth. An often-cited paper that highlighted the issue by demonstrating the presence of a statistically and economically significant negative relationship between volatility and growth was Ramey and Ramey (1995). Their data covered 92 countries for the period of 1962-1985; the dependent variable was per capita output growth, and volatility was measured as either realized or innovation variability in output growth. Ramey and Ramey estimation results implied that an increase in growth volatility was associated with lower per capita growth in the whole sample and OECD countries, respectively. Importantly, this negative relationship was robust to controlling for the investment-to-GDP ratio, which meant that volatility was reducing growth not (only) by lowering investments but via some other mechanism(s) as well. More recent re-estimations of the Ramey and Ramey equations using updated data series up to 2000 (Aghion, Angeletos, Banerjee and Manova 2005) confirm these results, though the negative volatility coefficient is not longer statistically significance for the OECD sub-sample. Our aim is to update these estimations by including more recent observations with a special focus on emerging market countries. More specifically, in light of the recent financial crisis, we are interested in testing their finding that a lower degree of financial development leads to a stronger negative effect of volatility on growth.

Our data consist of annual series for the period 1960-2009 mostly obtained from the IMF’s International Financial Statistics (IFS). We consider OECD countries and selected emerging market countries. We regress the average rate of productivity growth by initial income, a measure of macroeconomic volatility, a measure of financial sector development and country specific control variables (investments, population growth, school enrollment, government size, inflation, trade openness, intellectual property rights, property rights).

With the inclusion of recent data we expect to find a statistically negative relationship between the average long-run economic growth and macroeconomic volatility. We argue that in general successful stabilisation policies also have a long-run impact on economic growth.