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Volatility and Growth$
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Philippe Aghion and Abhijit Banerjee

Print publication date: 2005

Print ISBN-13: 9780199248612

Published to Oxford Scholarship Online: January 2007

DOI: 10.1093/acprof:oso/9780199248612.001.0001

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Financial Development and the Effects of Volatility on Growth

Financial Development and the Effects of Volatility on Growth

(p.23) 2 Financial Development and the Effects of Volatility on Growth
Volatility and Growth

Phillippe Aghion (Contributor Webpage)

Abhijit Banerjee (Contributor Webpage)

Oxford University Press

This chapter argues, based on Aghino-Angeletos-Banerjee-Manova (AABM), that the presence of credit constraints can help us understand why volatility is so costly for growth. The basic idea behind this explanation is rather obvious: The long-term productivity-enhancing investment in the model developed in the previous chapter creates a need for liquidity; with perfect credit markets the necessary liquidity is always supplied. Not so with imperfect credit markets: The liquidity shock is only financed when the firm has enough profits, because only profitable firms can borrow a lot. A negative productivity shock, by making firms less profitable, makes it less likely that the liquidity need would not be met. As a result, a fraction of the potentially productivity-enhancing long-term investments will go to waste, with obvious consequences for growth.

Keywords:   credit constraints, credit markets, liquidity, productivity shock, investments

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