Financial Volatility and its Economic Effects

Abstract

I empirically investigate the economic effects of uncertainty about the performance of financial firms. More specifically, I focus on the simple standard deviation of stock market returns across financial firms at every quarter, referring to this measure as financial volatility. First, I show that the idiosyncratic risk highlighted by models with a financial accelerator channel is an important exogenous component of this measure. Then, using a dynamic stochastic general equilibrium model and structural vector autoregressions, I show that exogenous movements in financial volatility cause substantial and persistent effects in credit, investment, and GDP; account for about 20% of the variation in these variables; and have played an important role during the last two credit crunches: the early 1990s recession and the Great Recession. Additionally, I show evidence of a feedback effect between credit spreads and financial volatility.

Keywords: Financial Volatility, Great Recession, Uncertainty, Financial Frictions

JEL Classification: C11, C32, E30, E44, G01