Financial Development, Fiscal Policy and Macroeconomic Volatility

This thesis examines empirically the effect of financial frictions and public debt on economic variables and seeks for an appropriate fiscal consolidation strategy.
First, the thesis explores the determinants of output volatility, especially the roles of financial development and government debt. The analysis, based on a panel of 127 countries over four decades, employs system GMM dynamic panel regression. According to the regression results financial development is estimated to have a non-linear effect on output volatility. Increased government debt levels are statistically associated with increased macroeconomic volatility. However, we need to interpret the results carefully due to endogeneity problems. The effect of the interactions between the two is insignificant.
Second, it analyses the role of financial frictions on economic fluctuations. When the three models are compared with the U.S. data along the second moments, the firm friction model helps in fitting some macroeconomic variables and outperforms the other models. In the impulse response functions, we find that financial frictions greatly amplify and propagate the effects of the exogenous shocks on economic variables. Specially, the firm friction model shows more persistent response than the bank friction model. In addition, the size of the response depends on the leverage in the model with financial frictions.
Third, the thesis considers how the effects of fiscal policy consolidation differ depending on alternative strategies. To do this, we develop an open economy DSGE model with an endogenous risk premium mechanism. The government consumption cut has larger negative effects on output than the government investment cut because of a complementarity with private consumption. The response of the tax hike is smaller than the expenditue cut because the tax hikes reduce more debts and the lower risk premium crowds in consumption and investment. Among three fiscal rules, the expenditure adjusted rule is the most effective for both preventing the economic downturn and reducing government debt.