On the Estimation of the Volatility-Growth Link
CREATES Research Paper 2012-21
13 Pages Posted: 8 Oct 2014
Date Written: October 1, 2014
It is common practice to estimate the volatility-growth link by specifying a standard growth equation such that the variance of the error term appears as an explanatory variable in this growth equation. The variance in turn is modeled by a second equation. Hardly any of existing applications of this framework includes exogenous controls in this second variance equation. Our theoretical findings suggest that the absence of relevant explanatory variables in the variance equation leads to a biased and inconsistent estimate of the volatility-growth link. Our simulations show that this effect is large. Once the appropriate controls are included in the variance equation consistency is restored. In short, we suggest that the variance equation must include relevant control variables to estimate the volatility-growth link.
Keywords: volatility and growth, growth regression, endogenous variance, unbiased estimates
JEL Classification: E32, O47
Suggested Citation: Suggested Citation