The recent global economic downturn in a number of economies was preceded by rising credit market risk brought on by a massive financial market failure. This paper develops a small open economy model that analyzes the interaction of business cycle volatilities with capital accumulation and the subsequent impacts on economic growth. We use a stochastic dynamic programming model to test the central hypothesis that rising volatility shocks is an inhibitor to capital accumulation and subsequently economic growth. The model illustrates that traditional capital-based growth models which assume a constant capital stock are not consistent with the business cycle variation in capital accumulation.

Furthermore, it appears that an increase in precautionary savings arising from a stochastic shock does not completely translate into productive capital investment need for growth, since risk-averse households will seek out risk-free government or foreign assets. We find this conclusion consistent with the empirical findings of Ramey et al (1995) and Badinger (2009) who both argued that, business cycle volatility is important to the growth discussion because of its robust net negative effect on output growth.