A Ricardian-type set-up is used to explore the linkage between financial development and the business cycle. Though financial advancement may be good for growth due to making possible a higher degree of division of labor, it may, for the same reason, be bad for the business cycle. Building on the duality between financial risk diversification and technological risk diversification the paper presents theoretical evidence that financial sophistication while providing ample income insurance may have a macroeconomic downside which shows in larger aggregate output fluctuations. Using a panel data set covering 22 OECD countries over the period 1970 through 2000 we present preliminary empirical evidence corroborating the proposition that financial advancement destabilizes the overall business cycle.
macroeconomic fluctuation financial system stock market panel analysis