Their measure of credit constraints is the ratio of private credit to GDP. Consistent with their model's predictions, the authors find that financial development mitigates the effect that volatility has on output growth.

Aghion et al. (2009) show that real exchange rate volatility has a more negative effect on economic growth in less financially developed countries. Based on a panel of 83 countries during 1960-2000, the authors find quantitatively large negative effects of exchange rate volatility on growth in countries with thin financial markets. To explain the empirical results, Aghion et al. build an open economy general equilibrium model with sticky wages and where firms face credit constraints. An exchange rate appreciation reduces firms' earnings and hence makes the credit constraint more likely to be binding. Exchange rate depreciation has the opposite effect; however, the presence of the credit constraint implies that the negative effects on output outweigh the positive effects. Consequently, the more severe credit constraints, the more negative is the effect of exchange rate volatility on growth.

Rodriguez (2014) examines how the impact of volatility on economic growth depends on financial development and fiscal policy cyclicality. Rodriguez finds that: (i) the negative impact of volatility on economic growth is exacerbated by financial underdevelopment; (ii) in financially underdeveloped economies countercyclical fiscal policy reduces the negative impact that volatility has on economic growth.

# **4. Empirical Results**

# **4.1 Graphical Analysis**

Before we discuss the results from the econometric analysis, it is useful to first illustrate graphically the relationship between volatility and economic growth. Figure 2 plots on the y-axis countries' average GDP per capita growth (over five years); on the x-axis is the standard deviation of the terms of trade growth rate (also computed over a five year period). We see from Panel A in Figure 2 that for a sample of 175 countries terms of trade volatility has a negative average effect on economic growth. The coefficient from a bivariate regression that corresponds to the plot in Panel A of Figure 2 is -0.31; this coefficient is significant at the 1 percent level (p-value 0.007). Panel B shows that a negative relationship between terms of trade volatility and economic growth is visible also within the sub-sample of OECS countries. The coefficient from a bivariate regression that corresponds to the plot in Panel B of Figure 2 is -0.36; thus it is quantitatively very close to the slope coefficient that emerges in Panel A. Statistically, we cannot reject the hypothesis that the slope coefficient in Panel A is equal to the slope coefficient in Panel B (t-value 0.91).

Figure 3 plots the unconditional relationship between economic growth and terms of trade volatility based on cross-country time-series variation in these variables. Panel A plots this relationship using all observations; Panel B excludes outliers. Both panels show that the crosscountry time-series relationship between economic growth and terms of terms volatility is negative. The slope coefficient in Panel A is -0.24 and in Panel B it is -0.44. In Panel A the slope coefficient is significantly different from zero at the 5 percent level; in Panel B it is significantly different from zero at the 1 percent level.

In Figure 4 we plot the relationship between economic growth and terms of trade volatility based on cross-country time-series variation in these variables, conditional on country and time fixed effects. Panel A shows this relationship for all observations; Panel B restricts the observations to OECS countries. The scatter plots in Panels A and B of Figure 4 do not point to a systematic conditional relationship between economic growth and terms of trade volatility. Indeed, neither the 9