Financial intermediary development and growth volatility: Do intermediaries dampen or magnify shocks?

We assess the channels through which financial intermediaries affect economic volatility. Building on Bacchetta and Caminal (2000, Do capital market imperfections exacerbate output fluctuations? European Economic Review 44(3), 449–468) our theoretical model predicts that well-developed financial intermediaries dampen the effect of real sector shocks and magnify the effect of monetary shocks. Using a panel of 63 countries over the period 1960–1997 and using the volatility of terms of trade and inflation to proxy for real and monetary volatility, respectively, we find (i) weak evidence that financial intermediaries dampen the effect of terms of trade volatility, and (ii) some evidence that financial intermediaries magnify the impact of inflation volatility in countries where firms have little or no access to external finance through capital markets.