Governmental System and Economic Volatility Under Democracy

Abstract

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.