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Shaken and Stirred: Explaining Growth Volatility

Wiliam R. Easterly, Roumeen Islam, and Joseph Stiglitz
Pub. Date: April 1, 2000
Full Text: Adobe Acrobat (PDF) [69 KB]   

The economic history of the world is replete with recessions and depressions. From the bursting of the British South Sea Bubble and the French Mississippi Bubble in 1720 (which at least one economic historian claims delayed the industrial revolution by 50 years) to the industrial depressions of the 1870s and 1930s, to the Latin American middle income debt crisis, African low income debt crisis, ex-Communist output collapse, and East Asian financial crisis, crises have been a constant of market capitalism. Add to that the collapses that have accompanied non-economic shocks like wars, hurricanes, earthquakes, volcanoes, fires, pests, droughts, and floods, and it is a wonder that anyone in the world has economic security.

More recently, economic crises have often tended to go hand in hand with financial crises whose frequency and severity in developing countries has increased over the past quarter century. The causes and nature of these crises have differed. For example, those that characterized the debt crises of the 1980s were precipitated by profligate governments with large cash deficits and uncontrolled monetary policies. The more recent ones have occurred in countries which, for the most part, were following prudent macroeconomic policies, some of which had quite sophisticated institutional arrangements. The marked differences in the downturns in Latin America in the early 1980s and in East Asia in the late 1990s (and the Mexico crisis of 1994-95) means that we need a general framework for thinking about macroeconomic fluctuations—one that can encompass differences among countries. Furthermore, economic volatility is of importance not just because of the short run adverse effects on the poor. It has been shown to be negatively correlated with economic growth. There are thus ample reasons for trying to understand better the determinants of economic volatility.

This paper attempts to set forth a framework for thinking about growth volatility which is general enough to incorporate the important structural, institutional, and policy variations among countries which might account for differences in their macroeconomic performance. And it focuses particularly on the role of the financial sector. The paper is divided into 2 sections. The first discusses the importance of short run dynamic effects in determining long run outcomes, and the role of the financial sector, elements which to date, have not been sufficiently incorporated in traditional macroeconomic analysis. The second looks at the data, which reveal some interesting aspects of the determinants of volatility, namely the importance of the financial sector.


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