The Empirical Volatility-Growth Relationship: Is Economic Freedom the Missing Link? - Journal of Private EnterpriseCategories: Summer 2015 | FreedomJohn W. Dawson, Appalachian State University/index.php?action=ajax&rs=GDMgetPage&rsargs[]=2015 Journal of Private Enterprise vol 30 no 2 parte4.pdf&rsargs[]=0TheJournalofPrivateEnterprise30(2),2015,61–82TheEmpiricalVolatility-GrowthRelationship:IsEconomicFreedomtheMissingLink?JohnW.Dawson∗AppalachianStateUniversity______________________________________________________AbstractThispaperexaminestheroleofeconomicfreedomintheempiricalrelationshipbetweenbusinesscyclevolatilityandlong-rungrowthacrosscountries.Inadiversesampleofninety-ninecountries,accountingforeconomicfreedom’sinfluenceonvolatilitymitigatesoreveneliminatesthenegativeimpactofvolatilityongrowth.Evidencealsosuggeststhattheimpactofvolatilityongrowthisnothomogeneousacrosscountriesatdifferentlevelsoffreedom.Inparticular,volatilityhasanegativeimpactongrowthonlyincountriesatverylowlevelsofeconomicfreedom.Mixedresultsinpreviousstudiessuggestedamorecomplicatedrelationshipbetweenvolatilityandgrowth,buttherewasnoclearevidencethateconomicfreedomwasthemissinglink.__________________________________________________________JELcodes:E32,O43Keywords:businesscycles,volatility,growth,economicfreedomI.IntroductionRameyandRamey(1995)iswidelyregardedasthebenchmarkempiricalstudyoftherelationshipbetweenbusinesscyclevolatilityandlong-runeconomicgrowth.TheRameysreportanegativerelationshipbetweenvolatilityandgrowthinabroadcross-sectionofcountries.Anumberofmorerecentstudiesconfirmthefindingofanegativevolatility-growthrelationship,includingMartinandRogers(2000),FatasandMihov(2003),Mobarak(2005),Badinger(2010),andFurceri(2010).Stillotherrecentstudies,however,reportapositiverelationship;see,forexample,StastnyandZagler(2007)andLee(2010).TwostudiesthatpredateRameyandRamey—oftenignoredinthisliterature—alsoexaminethevolatility-growthrelationship.Intheirbroadsearchfordeterminantsofcross-country∗IamgratefultoJimGwartney,MarkStrazicich,sessionparticipantsatthe2014annualmeetingsoftheAssociationforPrivateEnterpriseEducationinLasVegas,andtwoanonymousrefereesforhelpfulcommentsthatimprovedthequalityofthispaper.Anyremainingerrorsaremyown.61/index.php?action=ajax&rs=GDMgetPage&rsargs[]=2015 Journal of Private Enterprise vol 30 no 2 parte4.pdf&rsargs[]=162J.Dawson/TheJournalofPrivateEnterprise30(2),2015,61–82growth,KormendiandMeguire(1985)andGrierandTullock(1989)findevidenceofapositiverelationshipbetweenvolatilityandgrowth.Atfirstglance,itseemsthattheavailableevidenceontheempiricalrelationshipbetweenvolatilityandgrowthiscontradictory.Acloserlookattheevidence,however,revealssomeinterestingpatternsinthedata.First,RameyandRamey’sfindingofanegativerelationshipinaninety-two-countrysamplebecomespositiveandstatisticallyinsignificantwhentheirsampleisrestrictedtocountriesbelongingtotheOrganisationforEconomicCo-operationandDevelopment(OECD).Similarly,KormendiandMeguire’spositiverelationshipisobtainedinasampleofforty-sevenmostlydevelopedcountries,andthepositiverelationshipsfoundinthestudiesbyStastnyandZaglerandbyLeeareobtainedinsamplesrestrictedtoOECDandGroupof7(G7)countries.Inaddition,DawsonandStephenson(1997)findnoevidenceofavolatility-growthrelationshipacrosstheU.S.states.Allofthisinformationsuggeststhatthegenerallyacceptednegativerelationshipbetweenvolatilityandgrowthmaynotbeanaccuratedescriptionoftheprocessatworkinmoredevelopedeconomies.Itisinterestingtoconsiderwhichcharacteristicofmoredevelopedeconomiesdrivesthispattern.Specifically,thispaperconsiderswhetherthevolatility-growthrelationshipvarieswithlevelsofeconomicfreedomacrosscountriesandwhethervolatilityisservingasaproxyforeconomicfreedominstudiesofthevolatilitygrowthrelationship.Itiswellknownthateconomicfreedomisanimportantdeterminantofgrowthacrosscountries;see,forexample,studiesbyDawson(1998)andbyGwartney,Lawson,andHolcombe(1999),amongmanyothers.1Morerecently,Lipford(2007)andDawson(2010)haveshownthateconomicfreedomisalsorelatedtobusinesscyclevolatilityacrosscountries.Itispossible,then,thatvolatilityisservingasaproxyforeconomicfreedominstudiesofthevolatility-growthrelationshipthatdonotexplicitlycontrolfordifferencesinfreedomacrosscountries.Itisalsopossiblethatvolatilityandgrowtharepositivelyrelatedorunrelatedincountrieswithhigherlevelsofeconomicfreedomandnegativelyrelatedincountrieswithlowerlevelsoffreedom.Suchpossibilitiescouldexplainwhyvolatilityandgrowtharenegativelyrelatedindiversesamplesofcountries,butfoundtobepositivelyrelatedor1DeHaan,Lundstrom,andSturm(2006)andHallandLawson(2014)provideusefulsurveysofthelargeliteratureoneconomicfreedomandgrowth./index.php?action=ajax&rs=GDMgetPage&rsargs[]=2015 Journal of Private Enterprise vol 30 no 2 parte4.pdf&rsargs[]=2J.Dawson/TheJournalofPrivateEnterprise30(2),2015,61–8263insignificantinsamplesrestrictedtomoredevelopedcountrieswherefreedomisatahigherandmoreuniformlevel.ItcanalsoexplainwhyvolatilityandgrowtharenotrelatedacrosstheU.S.stateswherefreedomisalsoatahigherandmoreuniformlevel.EvidenceprovidedbyGrierandTullockalsosupportsthisconjecture,whereapositivevolatility-growthrelationshipisfoundinalarge,diversesampleofcountriesusingaspecificationthatincludesseveralinstitutionalproxies—andthesizeandsignificanceofthevolatilitycoefficientisreducedwhenanexplicitmeasureofinstitutionsisincluded.Studiesthatfindanegativerelationshipbetweenvolatilityandgrowthinbroadsamplesofcountriesmayalsobeconsistentwiththeideathateconomicfreedommattersinthevolatility-growthrelationship.Ifsuchstudiesignoretheroleoffreedom,theanalysismayattributetovolatilitytheinfluencethatisactuallyduetofreedom.Thispaperexploresthepossibilitythateconomicfreedomisthemissinglinkintherelationshipbetweenmacroeconomicvolatilityandeconomicgrowth.Thenextsectionprovidesabrieftheoreticalperspectiveonthevolatility-growthrelationship.Thethirdsectiondiscussestheempiricalmodel,methodology,anddataindetail.Adiscussionoftheempiricalresultsappearsinthefollowingtwosections,andthefinalsectionoffersconcludingremarks.II.VolatilityandGrowth:ABriefTheoreticalPerspectiveIntermsoftheory,relativelylittleattentionhasbeenpaidtotheeffectofbusiness-cyclevolatilityonlong-runeconomicgrowth.Indeed,theliteraturesonbusinesscyclesandeconomicgrowthhaveexistedlargelyinisolationfromoneanother.Therearereasons,however,tobelievethatvolatilityandgrowthmayberelated.Forexample,economicuncertaintyandcreditconstraintsduringperiodsofincreasedmacroeconomicvolatilitymayreduceinvestment,capitalaccumulation,andpresumablygrowth.Alongsimilarlines,ifinvestmentistosomeextentirreversible,increasedvolatilitycanleadtolowerinvestmentandthuslowergrowth;see,forexample,Bernanke(1983).Bothofthesechannelssuggestanegativerelationshipbetweenvolatilityandgrowth.Therearealsoreasonstosuspectapositiverelationshipbetweenvolatilityandgrowth.Black(1987)suggeststhateconomiesfaceapositiverisk-returntrade-offwhereriskiertechnologies(thatultimatelyleadtohighervolatility)areadoptedonlyiftheyareexpectedtopayahigherreturnandhenceproducehighergrowth/index.php?action=ajax&rs=GDMgetPage&rsargs[]=2015 Journal of Private Enterprise vol 30 no 2 parte4.pdf&rsargs[]=364J.Dawson/TheJournalofPrivateEnterprise30(2),2015,61–82rates.Separately,Sandmo(1970)andMirman(1971)hypothesizethatmorevariableincomestreamsleadtohighersavings,moreinvestment,andpresumablymoregrowth.Thesechannelsbothimplyapositivevolatility-growthrelationship.Clearly,therearedifferentpossiblechannelsthroughwhichvolatilitymayaffectgrowth,somewithpositiveandsomewithnegativepredictedrelationships.Inaddition,differentchannelsmaybedominantindifferenteconomies,causingdifferentestimatedrelationshipsindifferentgroupsofcountries.Whichchanneldominatesinaneconomymaywelldependoncertaincharacteristicsinthateconomy.Inparticular,differentinstitutionalarrangementsmaydeterminewhichchannelisdominant.Forinstance,economieswithmoremarket-orientedinstitutions(i.e.,moreeconomicfreedom)maybeabletoadjusttovolatilitymorereadily,thusmitigatingthenegativeeffectofvolatilityoninvestment.Thisarrangementmay,inturn,resultinastatisticallyinsignificantorpositiveestimatedvolatility-growthrelationshipinhigh-freedomcountries.Similarly,myopicbehaviorincountrieswithlowlevelsofeconomicfreedommaydampenprecautionarysavingmotivesevenintimesofhighvolatility,thusreducingthepositiveinfluenceofvolatilityongrowth.Thisstructurecouldleaveanegativevolatility-growthrelationshipatworkinthesecountries.Whiletheprecedingtheoreticaldiscussionisobviouslyfarfromcomplete,thepointistoillustratethattheoryalonecannotsettlethedebateovertherelationshipbetweenvolatilityandgrowth.Moreover,thequestionofwhichtheoreticalrelationshipemergesinaneconomymaydependontheinstitutionalframework.Ultimately,itisanempiricalissue.Theanalysisintheremainderofthepaperaddressesthisempiricalquestion.III.EmpiricalModel,Methodology,andDataThefollowingempiricalspecificationistypicalofthatusedinstudiesofthevolatility-growthrelationship:∆lnyi=α+λσi+ΣjβjXji+εi.Thedependentvariable,∆lny,istheaverageannualgrowthrateofrealGDPpercapita.XjrepresentsacommonsetofconditioningvariablesfoundbyLevineandRenelt(1992)toberobustlyrelatedtogrowth.Theseconditioningvariablesincludetheinitialincomelevel,theinvestmentshareofGDP,andpopulationgrowth.σisthevolatilitymeasureandλisthecoefficientofinterest.Thisbasicspecificationisusedasastartingpointintheanalysisthatfollows.Title The Empirical Volatility-Growth Relationship: Is Economic Freedom the Missing Link?Authors/Creators: John W. Dawson, Appalachian State UniversityKeywords: business cycles, volatility, growth, economic freedomDawson, John W. / 2015. "The Empirical Volatility-Growth Relationship: Is Economic Freedom the Missing Link?." The Journal of Private Enterprise, 30(2): 61-82.
