 The Empirical Volatility-Growth Relationship: Is Economic Freedom the Missing Link? - Journal of Private EnterpriseCategories: Summer 2015 FreedomJohn W. Dawson, Appalachian State Universityindex.php?actionajaxrsGDMgetPagersargs2015 Journal of Private Enterprise vol 30 no 2 parte4.pdfrsargs0TheJournalofPrivateEnterprise302,2015,6182TheEmpiricalVolatility-GrowthRelationship:IsEconomicFreedomtheMissingLink?JohnW.DawsonAppalachianStateUniversity___AbstractThispaperexaminestheroleofeconomicfreedomintheempiricalrelationshipbetweenbusinesscyclevolatilityandlong-rungrowthacrosscountries.Inadiversesampleofninety-ninecountries,accountingforeconomicfreedomsinfluenceonvolatilitymitigatesoreveneliminatesthenegativeimpactofvolatilityongrowth.Evidencealsosuggeststhattheimpactofvolatilityongrowthisnothomogeneousacrosscountriesatdifferentlevelsoffreedom.Inparticular,volatilityhasanegativeimpactongrowthonlyincountriesatverylowlevelsofeconomicfreedom.Mixedresultsinpreviousstudiessuggestedamorecomplicatedrelationshipbetweenvolatilityandgrowth,buttherewasnoclearevidencethateconomicfreedomwasthemissinglink.___JELcodes:E32,O43Keywords:businesscycles,volatility,growth,economicfreedomI.IntroductionRameyandRamey1995iswidelyregardedasthebenchmarkempiricalstudyoftherelationshipbetweenbusinesscyclevolatilityandlong-runeconomicgrowth.TheRameysreportanegativerelationshipbetweenvolatilityandgrowthinabroadcross-sectionofcountries.Anumberofmorerecentstudiesconfirmthefindingofanegativevolatility-growthrelationship,includingMartinandRogers2000,FatasandMihov2003,Mobarak2005,Badinger2010,andFurceri2010.Stillotherrecentstudies,however,reportapositiverelationship;see,forexample,StastnyandZagler2007andLee2010.TwostudiesthatpredateRameyandRameyoftenignoredinthisliteraturealsoexaminethevolatility-growthrelationship.Intheirbroadsearchfordeterminantsofcross-countryIamgratefultoJimGwartney,MarkStrazicich,sessionparticipantsatthe2014annualmeetingsoftheAssociationforPrivateEnterpriseEducationinLasVegas,andtwoanonymousrefereesforhelpfulcommentsthatimprovedthequalityofthispaper.Anyremainingerrorsaremyown.61index.php?actionajaxrsGDMgetPagersargs2015 Journal of Private Enterprise vol 30 no 2 parte4.pdfrsargs162J.DawsonTheJournalofPrivateEnterprise302,2015,6182growth,KormendiandMeguire1985andGrierandTullock1989findevidenceofapositiverelationshipbetweenvolatilityandgrowth.Atfirstglance,itseemsthattheavailableevidenceontheempiricalrelationshipbetweenvolatilityandgrowthiscontradictory.Acloserlookattheevidence,however,revealssomeinterestingpatternsinthedata.First,RameyandRameysfindingofanegativerelationshipinaninety-two-countrysamplebecomespositiveandstatisticallyinsignificantwhentheirsampleisrestrictedtocountriesbelongingtotheOrganisationforEconomicCo-operationandDevelopmentOECD.Similarly,KormendiandMeguirespositiverelationshipisobtainedinasampleofforty-sevenmostlydevelopedcountries,andthepositiverelationshipsfoundinthestudiesbyStastnyandZaglerandbyLeeareobtainedinsamplesrestrictedtoOECDandGroupof7G7countries.Inaddition,DawsonandStephenson1997findnoevidenceofavolatility-growthrelationshipacrosstheU.S.states.Allofthisinformationsuggeststhatthegenerallyacceptednegativerelationshipbetweenvolatilityandgrowthmaynotbeanaccuratedescriptionoftheprocessatworkinmoredevelopedeconomies.Itisinterestingtoconsiderwhichcharacteristicofmoredevelopedeconomiesdrivesthispattern.Specifically,thispaperconsiderswhetherthevolatility-growthrelationshipvarieswithlevelsofeconomicfreedomacrosscountriesandwhethervolatilityisservingasaproxyforeconomicfreedominstudiesofthevolatilitygrowthrelationship.Itiswellknownthateconomicfreedomisanimportantdeterminantofgrowthacrosscountries;see,forexample,studiesbyDawson1998andbyGwartney,Lawson,andHolcombe1999,amongmanyothers.1Morerecently,Lipford2007andDawson2010haveshownthateconomicfreedomisalsorelatedtobusinesscyclevolatilityacrosscountries.Itispossible,then,thatvolatilityisservingasaproxyforeconomicfreedominstudiesofthevolatility-growthrelationshipthatdonotexplicitlycontrolfordifferencesinfreedomacrosscountries.Itisalsopossiblethatvolatilityandgrowtharepositivelyrelatedorunrelatedincountrieswithhigherlevelsofeconomicfreedomandnegativelyrelatedincountrieswithlowerlevelsoffreedom.Suchpossibilitiescouldexplainwhyvolatilityandgrowtharenegativelyrelatedindiversesamplesofcountries,butfoundtobepositivelyrelatedor1DeHaan,Lundstrom,andSturm2006andHallandLawson2014provideusefulsurveysofthelargeliteratureoneconomicfreedomandgrowth.index.php?actionajaxrsGDMgetPagersargs2015 Journal of Private Enterprise vol 30 no 2 parte4.pdfrsargs2J.DawsonTheJournalofPrivateEnterprise302,2015,618263insignificantinsamplesrestrictedtomoredevelopedcountrieswherefreedomisatahigherandmoreuniformlevel.ItcanalsoexplainwhyvolatilityandgrowtharenotrelatedacrosstheU.S.stateswherefreedomisalsoatahigherandmoreuniformlevel.EvidenceprovidedbyGrierandTullockalsosupportsthisconjecture,whereapositivevolatility-growthrelationshipisfoundinalarge,diversesampleofcountriesusingaspecificationthatincludesseveralinstitutionalproxiesandthesizeandsignificanceofthevolatilitycoefficientisreducedwhenanexplicitmeasureofinstitutionsisincluded.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,Bernanke1983.Bothofthesechannelssuggestanegativerelationshipbetweenvolatilityandgrowth.Therearealsoreasonstosuspectapositiverelationshipbetweenvolatilityandgrowth.Black1987suggeststhateconomiesfaceapositiverisk-returntrade-offwhereriskiertechnologiesthatultimatelyleadtohighervolatilityareadoptedonlyiftheyareexpectedtopayahigherreturnandhenceproducehighergrowthindex.php?actionajaxrsGDMgetPagersargs2015 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parte4.pdfrsargs364J.DawsonTheJournalofPrivateEnterprise302,2015,6182rates.Separately,Sandmo1970andMirman1971hypothesizethatmorevariableincomestreamsleadtohighersavings,moreinvestment,andpresumablymoregrowth.Thesechannelsbothimplyapositivevolatility-growthrelationship.Clearly,therearedifferentpossiblechannelsthroughwhichvolatilitymayaffectgrowth,somewithpositiveandsomewithnegativepredictedrelationships.Inaddition,differentchannelsmaybedominantindifferenteconomies,causingdifferentestimatedrelationshipsindifferentgroupsofcountries.Whichchanneldominatesinaneconomymaywelldependoncertaincharacteristicsinthateconomy.Inparticular,differentinstitutionalarrangementsmaydeterminewhichchannelisdominant.Forinstance,economieswithmoremarket-orientedinstitutionsi.e.,moreeconomicfreedommaybeabletoadjusttovolatilitymorereadily,thusmitigatingthenegativeeffectofvolatilityoninvestment.Thisarrangementmay,inturn,resultinastatisticallyinsignificantorpositiveestimatedvolatility-growthrelationshipinhigh-freedomcountries.Similarly,myopicbehaviorincountrieswithlowlevelsofeconomicfreedommaydampenprecautionarysavingmotivesevenintimesofhighvolatility,thusreducingthepositiveinfluenceofvolatilityongrowth.Thisstructurecouldleaveanegativevolatility-growthrelationshipatworkinthesecountries.Whiletheprecedingtheoreticaldiscussionisobviouslyfarfromcomplete,thepointistoillustratethattheoryalonecannotsettlethedebateovertherelationshipbetweenvolatilityandgrowth.Moreover,thequestionofwhichtheoreticalrelationshipemergesinaneconomymaydependontheinstitutionalframework.Ultimately,itisanempiricalissue.Theanalysisintheremainderofthepaperaddressesthisempiricalquestion.III.EmpiricalModel,Methodology,andDataThefollowingempiricalspecificationistypicalofthatusedinstudiesofthevolatility-growthrelationship:lnyiαλσiΣjβjXjiεi.Thedependentvariable,lny,istheaverageannualgrowthrateofrealGDPpercapita.XjrepresentsacommonsetofconditioningvariablesfoundbyLevineandRenelt1992toberobustlyrelatedtogrowth.Theseconditioningvariablesincludetheinitialincomelevel,theinvestmentshareofGDP,andpopulationgrowth.σisthevolatilitymeasureandλisthecoefficientofinterest.Thisbasicspecificationisusedasastartingpointintheanalysisthatfollows.Title The Empirical Volatility-Growth Relationship: Is Economic Freedom the Missing Link?AuthorsCreators: 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, 302: 61-82. 