Governmental System and Economic Volatility in Democracies
AEI Economics Working Paper No. 2018-06
35 Pages Posted: 25 May 2018 Last revised: 23 Jul 2018
Date Written: June 6, 2018
Economic volatility varies substantially across democracies. We study how the difference between federal and unitary systems of government can contribute to these variations. We show empirically that a higher degree of federalism is associated with less volatility in both economic growth and fiscal policy. Motivated by these stylized facts, we develop a macroeconomic model of policy-making at the central and district levels. Policy at the central level is uncertain due to uncertainty about the identity of the winning coalition in a legislature of district representatives, while policy at the district level is more stable due to homogeneity within districts. We show that, in equilibrium, the decentralization of policy-making powers can mitigate overall policy uncertainty. This implies less volatility in fiscal policy and, hence, less volatility in economic growth, compared to those in a more unitary system.
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