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The Stabilizing Role of Government Size

  • Rafael Domenech

    ()

    (International Economics Institute, University of Valencia)

  • Javier Andres

    (International Economics Institute, University of Valencia)

  • Antonio Fatas

    (INSEAD)

This paper presents an analysis of how alternative models of the business cycle can replicate the stylized fact that large governments are associated with less volatile economies. Our analysis shows that adding nominal rigidities and costs of capital adjustment to an otherwise standard RBC model can generate a negative correlation between government size and the volatility of output. However, in the model, we find that the stabilizing effect is only due to a composition effect and it is not present when we look at the volatility of private output. Given that empirically we also observe a negative correlation between government size and the volatility of consumption, we modify the model by introducing rule-of-thumb consumers. In this modified version of our initial model we observe that consumption volatility is also reduced when government size increases in similar way to the observed pattern in OECD economies over the last 45 years.

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Paper provided by International Economics Institute, University of Valencia in its series Working Papers with number 0603.

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Length: 25 pages
Date of creation: Oct 2006
Date of revision: Jan 2007
Handle: RePEc:iei:wpaper:0603
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