Government Expenditure and Economic Growth: Evidence from Trivariate Causality Testing

Abstract

This paper seeks to examine if the relative size of government (measured as the share of total expenditure in GNP can be determined to Granger cause the rate of economic growth, or if the rate of economic growth can be determined to Granger cause the relative size of government. For this purpose, we first use a bivariate error correction model within a Granger causality framework, as well as adding unemployment and inflation (separately) as explanatory variables, creating a simple 'trivariate' analysis for each of these two variables. The combined analysis of bivariate and trivariate tests offers a rich menu of possible causal patterns. Using data on Greece, UK and Ireland, the analysis shows: i) government size Granger causes economic growth in all countries of the sample in the short run and in the long run for Ireland and the UK; ii) economic growth Granger causes increases in the relative size of government in Greece, and, when inflation is included, in the UK. JEL classification codes: H21

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“…Thus the previous bivariate causality tests between energy consumption and economic growth may be invalid due to the omission of important variables affecting both energy consumption and economic growth. It is possible that the introduction of capital and labor in the causality framework may not only alter the direction of causality but also the magnitude of the estimates (Loizides and Vamvoukas, 2005;Odhiambo, 2008). Further, since a four VAR case incorporates more information than the bivariate case, the causal inference drawn can be more reliable (Loizides and Vamvoukas, 2005).…”

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