This paper provides evidence of a causal and economically important effect of financial development on volatility. In contrast to the existing literature, the identification strategy is based on the differences in sensitivities to financial conditions across industries. The results show that sectors with larger liquidity needs are more volatile and experience deeper crises in financially underdeveloped countries. At the macro level, the results suggest that changes in financial development can generate important differences in aggregate volatility. An additional finding of this paper is that financially underdeveloped countries partially protect themselves from volatility by concentrating less output in sectors with large liquidity needs. Nevertheless, this insulation mechanism seems to be insufficient to reverse the effects of financial underdevelopment on withinsector volatility. Finally, this paper provides new evidence that: (i) financial development affects volatility mainly through the intensive margin (output per firm); (ii) both, the quality of information generated by firms, and the development of financial intermediaries, have independent effects on sectoral volatility, (iii) the development of financial intermediaries is more important than the development of equity markets for the reduction of volatility. * I am grateful to Daron Acemoglu and Ricardo Caballero for extremely helpful comments and discussion. Comments by Manuel Amador, Olivier Blanchard, Toan Do, Eduardo Engel, Barret Kirwan, Thomas Phillipon, Joachim Voch, and participants to the MIT macro lunch and seminar are also gratefully acknowledged. I am also grateful to David Autor and Raghuram Rajan for providing me access to their data. The views expressed in this paper are the author's only and do not necessarily represent those of the World Bank, its executive directors, or the countries they represent.
External shocks, such as commodity price fluctuations, natural disasters, and the role of the international economy, are often blamed for the poor economic performance of low-income countries. This paper quantifies the impact of these different external shocks using a panel vector auto-regression approach and compares their relative contributions to output volatility in lowincome countries vis-a-vis internal factors. We find that external shocks can only explain a small fraction of the output variance of a typical low-income country. Internal factors are the main source of fluctuations. From a quantitative perspective, the output effect of external shocks is typically small in absolute terms, but significant relative to the historic performance of these countries.
The Policy Research Working Paper Series disseminates the findings of work in progress to encourage the exchange of ideas about development issues. An objective of the series is to get the findings out quickly, even if the presentations are less than fully polished. The papers carry the names of the authors and should be cited accordingly. The findings, interpretations, and conclusions expressed in this paper are entirely those of the authors. They do not necessarily represent the views of the International Bank for Reconstruction and Development/World Bank and its affiliated organizations, or those of the Executive Directors of the World Bank or the governments they represent.
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