We argued in Chapter 0 that credit constraints are an important part of life, especially in the developing world. In this chapter we argue, based on Aghion-Angeletos-Banerjee-Manova (AABM), that the presence of credit constraints can help us understand why volatility is so costly for growth.

The basic idea behind our explanation is rather obvious: The long-term productivity-enhancing investment in the model developed in the previous chapter creates a need for liquidity; with perfect credit markets the necessary liquidity is always sup­plied.

An empirical implication of this approach is that countries with better financial markets will deal better with volatility. We test this in a cross-section of 70 countries over the period 1960-95 and find, like RR, a strong direct negative effect of volatility on growth, and that productivity growth is less sensitive to volatility when the degree of financial development is higher. However, it is not clear that this result can be causally inter­preted, since volatility is endogenous, and is clearly influenced by the level of financial development. We thus also report panel regressions from AABM of the response of per capita growth to exogenous changes in the terms of trade and an export- weighted measure of price commodity shocks, both annually and at 5-year intervals. Looking at 5-year averages, in a sample of 73 countries between 1960 and 1985 they find that deteri­orations in the terms of trade are less harmful to productivity

growth in countries with higher financial development. This result is robust to alternative measures of current or lagged credit constraints.

Finally, the model developed in this section predicts that long­term innovative investment should be more cyclical in more credit-constrained economies. Based on an annual panel of 14 OECD countries over the period 1973-97, AABM find that, as predicted by the theory, the ratio of R&D (which is taken as a proxy of long-term investment) over total investment responds more procyclically to lagged commodity-price shocks when the country is at a low level of financial development. On the other hand, total investment as a share of GDP does not respond in any systematic way to commodity-price shocks, suggesting that the effect of shocks on future growth is actually channeled through the reallocations of capital between short-term and long-term investments.

2.1