Financial sector ups and downs and the real sector in the open economy: Up by the stairs, down by the parachute

We examine how financial expansion and contraction cycles affect the broader economy through their impact on real economic sectors in a panel of countries over 1960-2005. Periods of accelerated growth of the financial sector are more likely to be followed by abrupt financial contractions than are periods of slower financial sector growth. Sharp fluctuations in the financial sector have strongly asymmetric effects, with the majority of real sectors adversely affected by contractions, but not helped by expansions. The adverse effects of financial contractions are transmitted almost exclusively through the financial openness channel, with precautionary foreign exchange reserve holdings serving as a key buffer.

Keywords: financial cycles, financial and trade openness, real transmission of financial shocks, foreign exchange reserves

JELclassification: F15, F31, F36, F4