Wednesday, July 4, 2012

Policy Volatility, Institutions and Economic Growth

FATAS Antonio, MIHOV Ilian
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Review of Economics and Statistics 95, 2 (2013) 362-376

In this paper we present evidence that policy volatility exerts a strong and direct negative impact on growth. Using data for 93 countries, we construct measures of policy volatility based on the standard deviation of the residuals from country-specific regressions of government consumption on output. Undisciplined governments that implement frequent and large changes in government spending unrelated to the state of the business cycle generate lower economic growth. We employ both instrumental variables and panel estimation to address concerns of omitted variables and endogeneity. A one-standard-deviation increase in policy volatility reduces long-term economic growth by about 0.74% in the panel regressions, and by more than one percentage point in the cross-section.