Does Financial Integration Reduce Output Volatility? New Evidence from Cross-Country Data

Abstract

We examine the effect of financial integration, measured based on both volume and equity, on output volatility using five‐year non‐overlapping annual average data windows for sixty countries over the 1971–2015 period. We construct aggregate‐ as well as sub‐panels based on income and region. Financial integration reduces output volatility in aggregate and income panel, but not in all regions. Foreign direct investment (FDI) and foreign portfolio investment (FPI) reduces output volatility in developed countries, but only FDI reduces output volatility in developing countries. Financial regulatory architecture should aim at attracting FDI and macroeconomic and structural reforms to reap the benefits of FPI flows.