Government size and output volatility: is there a relationship?

This paper provides some further tests for the proposition that a larger public sector leads to smaller out-put volatility. Both Gali and Fatas & Mihov have provided some evidence which appears to support this proposition. Their evidence is, however, based on a relatively small sample of countries. In this study, we go beyond the OECD sample and focus on a much larger World Bank data set covering up to 208 countries for the period 1960–2002. We also seek to utilise some time series aspects of the material by using pooled cross-section time series data. Tests with different models and measures clearly indicate that the original results are not very robust and the relationship between government size and output volatility is either nonexistent or very weak at best.

Introduction: Recently, the role of automatic stabilisers and the effectiveness of fiscal policy in general have become important issues in Europe, at least. The explanation is obvious: Euro and The Stability and Growth Pact (SGP). The importance of the issue has increased along with the recent structural and cyclical public sector financing problems which no more can be rescued by monetary policy measures. The evaluation of the effectiveness of fiscal policy is a quite complicated matter because it requires that we are able to control the key economic variables and shocks. Basically, it would require a large macro-model which would among other things include all key fiscal policy parameters and behavioural equations and which would facilitate an evaluation of so-called automatic stabilisers. Although in the past several attempts have been made to assess the effectiveness of policy by using macro-model based approach it is now generally considered that some simpler devices have be found for that purpose.

Author: Matti Virén

Source: Research Discussion Papers, Bank of Finland

Download URL 2: Visit Now