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Volatility and growth: Credit constraints and the composition of investment

Philippe Aghion, George-Marios Angeletos (), Abhijit Banerjee and Kalina Manova

Scholarly Articles from Harvard University Department of Economics

Abstract: This paper examines how uncertainty and credit constraints affect the cyclical composition of investment and thereby volatility and growth. We develop a model where ï¬ rms engage in two types of investment: a short-term one; and a long-term one, which contributes more to productivity growth. Because it takes longer to complete, long-term investment has a relatively less cyclical return; but it also has a higher liquidity risk. The ï¬ rst effect ensures that the share of long-term investment to total investment is countercyclical when ï¬ nancial markets are perfect; the second implies that this share may turn procyclical when ï¬ rms face tight credit constraints. The contribution of the paper is thus to identify a novel propagation mechanism: through its effect on the cyclical composition of investment, tighter credit can lead to both higher volatility and lower mean growth. Evidence from a panel of countries provides support for the model’s key predictions.

Date: 2010
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Published in Journal of Monetary Economics

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