Enhancing Economic Activity by Mitigating Uncertainty: Exploring the Roles of the Financial System and Institutional Quality

Abstract

This paper investigates how financial development and institutional quality influence the negative impact of economic uncertainty on economic growth. Using a panel dataset of 32 countries covering the period 2004–2017, the study examines whether the institutional context can mitigate the adverse effects of uncertainty, and through which channels this effect is transmitted. To address potential endogeneity issues, we employ the system‐GMM estimation method and margin plot techniques. The overall level of financial development is measured using principal component analysis (PCA). The results show that financial development reduces the negative impact of uncertainty on economic growth through both the investment and consumption channels. Further analysis reveals that access to finance, financial depth, financial stability, and stock market depth all play significant roles in moderating this relationship. In contrast, financial efficiency shows no mitigating effect. Regarding institutional quality, government stability helps to lessen the adverse effects of uncertainty, while bureaucratic quality does not appear to have a significant influence. The findings highlight the importance of institutional context in shaping how uncertainty affects economic growth and contribute to the limited literature on the role of financial development in this relationship. This study also pioneers the analysis of how institutional quality interacts with financial development to influence the uncertainty–growth nexus. From a policy perspective, governments should promote financial system development to cushion the economy against uncertainty, and policymakers should consider the state of financial markets when designing strategies to sustain growth under uncertain conditions.