Abstract
The paper aims to examine how fiscal and monetary volatility might affect the balanced economic growth rate using a standard monetary growth model characterized by nominal wage rigidity and productive public spending. The model shows that any type of shock — monetary or fiscal — can generate either a negative or positive relationship between short-run volatility and long-run growth, critically depending on the size of government and the elasticity of output with respect to labor/capital. In particular, given the labor income share, it shows that excessive government spending may cause the impact of fiscal volatility on long-run growth to turn from positive to negative. In addition, a rise in the volatility of the monetary shock is capable of generating either an increase or decrease in the mean of growth. With the range of the labor share values in reality, the model produces results consistent with the fact that the relationship between volatility and growth is generally found empirically to be more negative in developing than in developed countries. The model can be seen as a further explanation for the ambiguous empirical evidence in the existing literature.
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Notes
The assumption that utility is additively separable in consumption, real money balances, and labor supply allows for closed-form solutions. The budget constraint is also written without bond holdings for analytical convenience. For further simplicity, I also abstract from preference or technology shocks, since these shocks have been examined thoroughly in the existing literature.
If X and Y are independent random variables, then the second-order Taylor approximation of the expected value of the quotient X/Y is given by \( E\left[\frac{X}{Y}\right]\simeq \left(\frac{E\left[X\right]}{E\left[y\right]}\right)\left(1+\frac{Var\left[Y\right]}{{\left(E\left[Y\right]\right)}^2}\right) \).
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Pham, T.A. Policy volatility and growth. Port Econ J 17, 87–97 (2018). https://doi.org/10.1007/s10258-018-0144-6
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DOI: https://doi.org/10.1007/s10258-018-0144-6