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The Stabilizing role of government size

Author: Andres, Javier ; Doménech, Rafael ; Fatás, AntonioINSEAD Area: Economics and Political ScienceIn: Journal of Economic Dynamics and Control, vol. 32, no. 2, February 2008 Language: EnglishDescription: p. 571-593.Type of document: INSEAD ArticleNote: Please ask us for this itemAbstract: 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. The authors' 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, they 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 they also observe a negative correlation between government size and the volatility of consumption, they modify the model by introducing rule-of-thumb consumers. In this modified version of our initial model they observe that consumption volatility is also reduced when government size increases.
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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. The authors' 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, they 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 they also observe a negative correlation between government size and the volatility of consumption, they modify the model by introducing rule-of-thumb consumers. In this modified version of our initial model they observe that consumption volatility is also reduced when government size increases.

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