Financial sector development, economic volatility and shocks in sub-Saharan Africa

Working paper 648
Author(s): 
Muazu Ibrahim and Paul Alagidede
Publication date: 
November, 2016
Classification-JEL: 

The role of financial sector development in economic volatility has been extensively studied albeit without informative results largely on the failure of extant studies to decompose volatility into its various components. By disaggregating volatility, this study examines the effect of financial development on volatility as well as channels through which finance affects volatility components in 23 sub-Saharan African countries over the period 1980–2014 using the newly developed panel cointegration estimation strategy. Our findings reveal that while financial development affects business cycle volatility in a non-linear fashion, its effect on long run fluctuation is imaginary. More specifically, well developed financial sector dampens volatility at the business cycle. However, in the long run, unbridled financial development may magnify fluctuations. Further findings show that while monetary shocks have large magnifying effect on volatility, their effect in the short run is minuscule. The reverse however holds for real shocks. Our main conclusion is that irrespective of the component, volatility caused by monetary shocks is more important and persistent than those caused by real shocks and financial underdevelopment and factors driving fluctuations are largely internal. With regard to channels of manifestation, our evidence shows that whether in the short or long term, financial development dampens (magnifies) the effect of real shocks (monetary shocks) on the components of volatility with the dampening effects consistently larger only in the short run. Strengthening financial sector supervision, including cross-border oversight as well as adoption of inflation targeting may be very crucial in examining the right levels of finance and price stability necessary to falter economic fluctuations.

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