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Theoretical and empirical work on the relationship between finance or capital markets
and the various aspects of business cycles has been relatively scarce compared to a
large literature on finance and growth (Demirguc-Kunt and Levine, 2001). This gap is
quite surprising, given the importance of business cycles and the fact that economies with a
lower macroeconomic volatility are associated with faster growth (Ramey and Ramey, 1994).
This paper extends the previous research in this field by empirically investigating the effects
of capital markets on certain aspects of business cycles,
namely, frequency of recession, and the time the economy spends in recessionary periods.
Theoretically, capital market development would lower macroeconomic volatility.
The effect works through several channels. Firstly, corporate information is much
more accessible in an economy with developed capital markets as investors would require
both transparency and disclosure in order to invest directly in particular firms. In other
words, capital market development helps reduce existing information asymmetry in
financial markets, and according to Greenwald and Stiglitz (1993), this would lead to lower
volatility. Secondly, by allowing firms and investors easier access to saving and investment
opportunity respectively, capital market development would reduce a market imperfection in the form
of an unequal access to investment across individuals. Since this imperfection would
generate endogenous aggregate fluctuations (Aghion
et al., 1999), capital market development
would reduce macroeconomic fluctuation. Thirdly, Acemoglu and Zilibotti (1997) argue that
the existence of indivisible projects, limits the extent of diversification that the economy
can achieve. This limit on diversification of idiosyncratic risk and the desire to avoid
risky investments combine to deter capital accumulation and introduce large uncertainities into
the growth process. Therefore, by providing better diversification for both entrepreneurs
and investors, capital market development would dampen cyclical fluctuation. Lastly,
capital market development would make lending decisions rely less on long-term relationship.
Haan et al. (1999) suggest that this long-term relationship is vulnerable to break up in
periods of low liquidity and the breakups would lead to feedbacks between investment and
financial intermediation that magnify the effect of shocks. Since lending decision depends less on
this relationship in the economy with more developed capital markets, the effect of adverse
shocks is dampened. |
