Macroeconomic Volatility and Economic Freedom: A Cross-Country Analysis

Abstract

This paper examines the empirical relationship between business cycle volatility and economic freedom across countries. In a diverse sample of 85 countries, the results suggest a significantly negative relationship between volatility and a broad measure of freedom—even after controlling for other determinants of cross-country volatility and using an instrumental variables procedure to account for the likely endogeneity of economic freedom. Among the underlying areas of the freedom index, all but the size of government component also have a significantly negative relationship with volatility. Size of government is found to have a significantly positive relationship with volatility. Measures of changes in freedom and the volatility of freedom are found to be statistically insignificant, suggesting that freedom is not among the shocks that cause business cycles. Rather, freedom appears to allow economies to better adjust to those shocks that drive business cycles. Key Words: business cycles, volatility, institutions, economic freedom