On the role of government in a stochastically growing open economy

The relationship between the size of government, economic growth, and volat ility in a small open economy is analyzed. First, we characterize the stoch astic equilibrium for a centrally planned economy, contrasting it with a cl osed economy. The role of government consumption expenditure both as a stab ilizing and a destabilizing factor is discussed. The optimal size of govern ment is derived and we find that an open economy will have a larger governm ent if and only if it is a net creditor. Second, the stochastic equilibrium in a decentralized economy is characterized and the optimal tax structure derived. Finally, the role of government production expenditure and its imp act on risk is briefly discussed. (C) 1999 Elsevier Science B.V. All rights reserved.