Optimal Fiscal Policy in an Economy Facing Socio-Political Instability

Abstract

We present a model of optimal government policy when policy choices may exacerbate socio-political instability (SPI). We show that optimal policy that takes into account SPI transforms a standard concave growth model into a model with both a poverty trap and endogenous growth. The resulting equilibrium dynamics inherit the properties of government policies and need not be monotone. Indeed, for a broad set of conditions we demonstrate that government policy is unable to eliminate the poverty trap; when these conditions do not hold, "most" countries eventually reach a balanced growth path. The predictions of the model are tested by developing three new measures of SPI for a panel of 58 countries. Estimating optimal policies and the growth equation derived from the model reveals strong support for the theory. In particular, we show via simulations that optimal funding for public investment and the police cause a typical developing economy to expand on a quasi-linear growth path, with the baseline level of SPI determining whether growth is positive or negative.Socio-Political Instability, Endogenous Growth, Public Investment, Political Economy of Growth