Abstract
This paper analyzes the impact of financial openness on the size of the government in a stochastically growing small open economy when public spending is productive and volatility-reducing using a portfolio approach. The main result of the model is that economies that are more open are associated with a smaller productive public sector. The lower risk associated with more open economies due to risk diversification implies that the government is less inclined to increase the scale of its activity to maximize welfare when productive spending is also volatility-reducing. The empirical evidence based on a sample of 16 OECD countries for the period 1970–2004 broadly supports the main results of the model, even though some results are mixed.
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I deeply thank Javier Gardeazabal for all his help. I also thank an anonymous referee, the Co-Editor Claudio Michelacci, Cruz Ángel Echevarría, Asier Minondo, Jesús Vázquez, Rafael Doménech, Antonio Fatás, José García-Solanes, Salvador Ortigueira, Philippe Bacchetta, Javier Coto-Martínez, and seminar participants at the XX Congress of the European Economic Association for their very helpful suggestions and comments. The financial support of Diputación Foral de Gipuzkoa (through the Departamento para la Innovación y la Sociedad del Conocimiento, via Red Guipuzcoana de Ciencia y Tecnología) and Gobierno Vasco (through the Grant Program to support the activities of research teams from the Basque University System) is gratefully acknowledged. The remaining errors and omissions are entirely the responsibility of the author. The data used in this paper are available at http://paginaspersonales.deusto.es/ineraus/.
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Erauskin, I. Financial openness, volatility, and the size of productive government. SERIEs 2, 233–253 (2011). https://doi.org/10.1007/s13209-010-0029-0
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DOI: https://doi.org/10.1007/s13209-010-0029-0