Financial development, fiscal policy and volatility: Their effects on growth

This paper analyzes how fiscal policies and credit constraints can affect the impact of macroeconomic volatility on long-run growth. The model by Aghion et al. (2005) is extended by allowing for governmental fiscal policy over the business cycle. The analysis shows that in an economy facing credit constraints, an increase in volatility will result in lower mean growth, and all the more the less financially developed and the more procyclical the fiscal policy is. The main implication is that in countries with lower degrees of financial development, countercyclical fiscal policies are particularly important in reducing the negative consequences of adverse aggregate shocks on firms' long-run investments. An empirical analysis is finally conducted using different groups of countries that confirm the theoretical predictions.