Working Paper Series no. 139: Illiquidity, Financial Development and the Growth-Volatility Relationship

Abstract

This paper studies how financial development affects the relation between average growth and growth volatility through liquidity crises. We .first establish in a micro model that imperfect enforceability creates a short term bias in contracts financing long term investments. This can generate maturity mismatches between firms' assets and liabilities and lead to liquidity crises. Then with this mechanism, we show in a macro framework that the relation between average growth and growth volatility is more likely to be negative in developing countries, but more likely to be positive in developed economies. Finally we provide empirical evidence which supports the prediction of the model.

Enisse Kharroubi
February 2006

Classification JEL : E44, G30, O16.

Keywords : Illiquidity, debt maturity, growth, volatility, financial development.