Financial Volatility and Economic Activity

54 Pages Posted: 7 Nov 2009

See all articles by Fabio Fornari

Fabio Fornari

European Central Bank (ECB)

Antonio Mele

University of Lugano; Swiss Finance Institute; Centre for Economic Policy Research (CEPR)

Date Written: November 6, 2009

Abstract

Does capital markets uncertainty act the business cycle? We nd that financial volatility predicts 30% of post-war economic activity in the United States, and that during the Great Moderation, aggregate stock market volatility explains, alone, up to 55% of real growth. In out of-sample tests, we nd that stock volatility helps predict turning points over and above traditional financial variables such as credit or term spreads, and other leading indicators. Combining stock volatility and the term spread leads to a proxy for (i) aggregate risk, (ii) risk-premiums and (iii) monetary policy, which is found to track, and anticipate, the business cycle. At the heart of our analysis is a notion of volatility based on a slowly changing measure of return variability. This volatility is designed to capture long-run uncertainty in capital markets, and is particularly successful at explaining trends in the economic activity at horizons of six months and one year.

Suggested Citation

Fornari, Fabio and Mele, Antonio, Financial Volatility and Economic Activity (November 6, 2009). Available at SSRN: https://ssrn.com/abstract=1501168 or http://dx.doi.org/10.2139/ssrn.1501168

Fabio Fornari (Contact Author)

European Central Bank (ECB) ( email )

Sonnemannstrasse 22
Frankfurt am Main, 60314
Germany

Antonio Mele

University of Lugano ( email )

Via Giuseppe Buffi 13
Lugano, Ticino 6900
Switzerland

Swiss Finance Institute

c/o University of Geneva
40, Bd du Pont-d'Arve
CH-1211 Geneva 4
Switzerland

Centre for Economic Policy Research (CEPR) ( email )

London
United Kingdom

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