How does financial development influence the impact of remittances on growth volatility? ☆ Ibrahim Ahamada a, b, ⁎, Dramane Coulibaly c a Paris School of Economics, France b University of Paris 1 Pantheon Sorbonne, France c CEPII (Centre d'Etudes Propectives et d'Informations Internationales), France abstract article info Article history: Accepted 24 August 2011 JEL classification: E32 F22 O16 Keywords: Remittances Financial development Growth volatility PSTR models This paper empirically examines how financial development influences the impact of remittances on GDP growth volatility. This empirical study is conducted using the panel smooth transition regression (PSTR) ap- proach. The results show that the impact of remittances on GDP growth volatility is nonlinear and changes over time and across countries in function of financial development. More precisely, a high level of financial development helps remittances to have a high stabilizing impact. Therefore, public authorities in remittance recipient countries might implement policies that promote the financial sector in order to allow a high stabi- lizing impact of remittances. Crown Copyright © 2011 Published by Elsevier B.V. All rights reserved. 1. Introduction Since it has been shown that volatility of GDP growth has a negative impact on growth, poverty and welfare, the literature has considered its determinants. 1 To this end, Chami et al. (2008) has examined whether remittances can help reduce growth volatility. They argue that there exist multiple pathways through which remittances can influence eco- nomic volatility, and these pathways imply contradictory effects. Remit- tances enable recipient households to smooth their consumption and investment over time. This implies that if they are large enough, remit- tances will reduce macroeconomic volatility in a remittance-receiving country. However, remittances may tend to increase economic volatility by changing remittance recipients' behaviors. Due to the moral hazard in terms of labor income, remittances may increase economic volatility, if, in the presence of remittances, household labor supply becomes more procyclical. 2 Moreover, due to the moral hazard in terms of investment effort, remittance recipients will undertake riskier projects or make less effort on their existing investment projects, leading to an increase in dis- persion of investment returns and hence an increase in output volatility. Using a cross-section of 70 countries, comprising 16 advanced economies and 54 developing countries, Chami et al. (2008) find that remittances help to reduce growth volatility. Bugamelli and Paternò (2009) use a cross-section of about 60 emerging and devel- oping economies and also find evidence that remittances decrease growth volatility. Estimating a panel model on a database containing 20 small island developing states (SIDS), Craigwell et al. (2009) find that remittance flows have a stabilizing influence on output and in- vestment volatility. More recently, using a panel data of 95 develop- ing countries, Craigwell et al. (2010) report that remittances can play a key role in mitigating the effect of adverse output shocks. The present paper considers an additional channel through which financial development can help remittances to have a stabilizing role. More precisely, this paper empirically tries to prove that a well Economic Modelling 28 (2011) 2748–2760 ☆ We thank anonymous referees for their helpful comments that allow us to improve the quality of our paper. We are grateful to Christophe Hurlin for kindly providing the MATLAB code used to perform the PSTR model. We are also grateful to Jean Claude Berthélemy, Valerie Mignon, Hubert Kempf and the participants to DIAL Development Conference on earlier drafts. We are responsible for all remaining errors. ⁎ Corresponding author at: Paris School of Economics and University Paris 1 Pantheon Sorbonne, France. Tel.: +33 1 44 07 83 50; fax: +33 1 44 07 82 47. E-mail address: ibrahim.ahamada@univ-paris1.fr (I. Ahamada). 1 Volatility entails a direct welfare cost for risk-averse individuals, as well as an indi- rect one through its adverse effect on income growth. The negative volatility–growth link was documented in Ramey and Ramey (1991), Ramey and Ramey (1995) and Acemoglu et al. (2003) among others. The relationship between volatility and poverty is based on the fact that recessions increase poverty significantly, while expansions decrease it in a more limited way (Agenor, 2002). 2 For example a negative technology by causing a decline in domestic income leads to an increase in remittances due to the countercyclical nature of these flows. In this case, the household would not increase its labor supply in response to the shock when remittances received are high. The household will take advantage of the remittance in- flows by choosing additional leisure over labor. 0264-9993/$ – see front matter. Crown Copyright © 2011 Published by Elsevier B.V. All rights reserved. doi:10.1016/j.econmod.2011.08.019 Contents lists available at SciVerse ScienceDirect Economic Modelling journal homepage: www.elsevier.com/locate/ecmod