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Financial openness and the size of the public sector: a portfolio approach

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  • Erauskin-Iurrita, Inaki

Abstract

A good deal of time has been devoted to whether more open economies have bigger governments (compensation hypothesis) or sma-ller ones (efficiency hypothesis). However, most of the research has been focused mainly on trade openness, which is clearly restrictive in a world with increasingly integrated financial markets. This paper offers an alternative view to the relationship between financial openness and some key economic variables (the size of the public sector, ...), based on a portfolio approach. A central result of the model is that an open economy implies a higher consumption-wealth ratio, lower growth, higher welfare, and a higher size of the public sector than in a closed economy due to the risk diversification that an open economy allows. The empirical evidence for 22 OECD countries in the period 1970-2004 broadly supports the main results of the model.

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File URL: http://mpra.ub.uni-muenchen.de/10619/
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Bibliographic Info

Paper provided by University Library of Munich, Germany in its series MPRA Paper with number 10619.

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Date of creation: 15 Sep 2008
Date of revision: 15 Sep 2008
Handle: RePEc:pra:mprapa:10619

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Keywords: Financial openness; consumption-wealth ratio; growth; welfare; optimal size of the public sector;

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References

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  1. Stephen Turnovsky, 1998. "On the Role of Government in a Stochastically Growing Open Economy," Discussion Papers in Economics at the University of Washington 0073, Department of Economics at the University of Washington.
  2. Campbell, John Y, 1996. "Understanding Risk and Return," Journal of Political Economy, University of Chicago Press, vol. 104(2), pages 298-345, April.
  3. Turnovsky, Stephen J., 1996. "Fiscal policy, growth, and macroeconomic performance in a small open economy," Journal of International Economics, Elsevier, vol. 40(1-2), pages 41-66, February.
  4. Stephen J. Turnovsky, 1997. "International Macroeconomic Dynamics," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262201119, January.
  5. Dani Rodrik, 1996. "Why Do More Open Economies Have Bigger Governments?," NBER Working Papers 5537, National Bureau of Economic Research, Inc.
  6. Barro, Robert J., 1990. "Government Spending in a Simple Model of Endogeneous Growth," Scholarly Articles 3451296, Harvard University Department of Economics.
  7. Kim, So Young, 2007. "Openness, External Risk, and Volatility: Implications for the Compensation Hypothesis," International Organization, Cambridge University Press, vol. 61(01), pages 181-216, January.
  8. Maurice Obstfeld, 1992. "Risk-taking, global diversification, and growth," Discussion Paper / Institute for Empirical Macroeconomics 61, Federal Reserve Bank of Minneapolis.
  9. Wacziarg, Romain & Alesina, Alberto, 1998. "Openness, Country Size and Government," Scholarly Articles 4553014, Harvard University Department of Economics.
  10. Merton, Robert C, 1969. "Lifetime Portfolio Selection under Uncertainty: The Continuous-Time Case," The Review of Economics and Statistics, MIT Press, vol. 51(3), pages 247-57, August.
  11. Lane, Philip R. & Milesi-Ferretti, Gian Maria, 2006. "The External Wealth of Nations Mark II: Revised and Extended Estimates of Foreign Assets and Liabilities, 1970-2004," CEPR Discussion Papers 5644, C.E.P.R. Discussion Papers.
  12. Stephen J. Turnovsky, 2000. "Methods of Macroeconomic Dynamics, 2nd Edition," MIT Press Books, The MIT Press, edition 2, volume 1, number 0262201232, January.
  13. Michael B. Devereux & Gregor W. Smith, 1991. "International Risk Sharing and Economic Growth," Working Papers 829, Queen's University, Department of Economics.
  14. Aart Kraay & Jaume Ventura, 2000. "Current Accounts In Debtor And Creditor Countries," The Quarterly Journal of Economics, MIT Press, vol. 115(4), pages 1137-1166, November.
  15. Devereux, Michael B. & Saito, Makoto, 1997. "Growth and risk-sharing with incomplete international assets markets," Journal of International Economics, Elsevier, vol. 42(3-4), pages 453-481, May.
  16. R. C. Merton, 1970. "Optimum Consumption and Portfolio Rules in a Continuous-time Model," Working papers 58, Massachusetts Institute of Technology (MIT), Department of Economics.
  17. Liberati, Paolo, 2007. "Trade openness, capital openness and government size," MPRA Paper 44371, University Library of Munich, Germany.
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