It is common practice to estimate the volatility-growth link by specifying a growth equation such that the variance of the error term appears as an explanatory variable. Hardly any of existing applications of this framework includes exogenous controls in the variance equation. We show that the absence of relevant explanatory variables in the variance equation is not innocuous, leading to an omitted variable problem with an biased and inconsistent estimate of the volatility-growth link. Our simulations suggest that this effect is large and should be addressed in the empirical work. Once the appropriate controls are included consistency is restored.
It is common practice to estimate the volatility-growth link by specifying a growth equation such that the variance of the error term appears as an explanatory variable. Hardly any of existing applications of this framework includes exogenous controls in the variance equation. We show that the absence of relevant explanatory variables in the variance equation is not innocuous, leading to an omitted variable problem with an biased and inconsistent estimate of the volatility-growth link. Our simulations suggest that this effect is large and should be addressed in the empirical work. Once the appropriate controls are included consistency is restored.