Output Fluctuations and Financial Market Development. Evidence from OECD Countries

This article examines the nature of the linkage between financial development and economic fluctuation in 22 OECD countries over the period from 1970 through 2000. Two econometric techniques are used: The first, a cross-sectional instrument variable estimator, deals, to some degree, with the potential problems caused by simultaneity, omitted variables and unobserved country-specific effects. The second technique to be applied is the standard fixed effects model, which is designed to capture variation across country and time periods in simple shifts of the regression function (i.e., changes in the intercepts). The results obtained by these techniques confirm that arm's length financing has a role in destabilising the business cycle in the OECD countries while relationship lending is neutral in this respect. The magnitude of the independent impact of the stock market on output growth fluctuation is significant. In accordance with theory, there is also a strong indication that both market-based and bank-based financial systems magnify the impact of monetary shocks on macroeconomic volatility whereas real shocks are dampened by well-developed financial systems. Finally, the results indicate that it is the interaction between stock market size and stock market volatility that matters as a source of business cycle destabilisation.