The Effect of Institutional Quality on Economic Volatility

This analysis investigates the relationship between institutional quality and measures of macroeconomic volatility and economic performance. Previous literature provides evidence that there is a positive effect of institutional quality on economic growth, while higher levels of institutional quality seem to decrease measures of macroeconomic volatility. This paper performs a panel data analysis to examine the impact of institutional quality on economic growth and macroeconomic volatility measured as inflation as well as the GARCH variance of real GDP. The Kaufmann World Governance Indicators (WGI) are used as a proxy for institutional quality and the sample includes 214 countries covering the years 1996-2012. It is shown that higher institutional quality increases economic growth. In addition to that, there seems to be a significant negative effect of institutional quality on macroeconomic volatility, as measured by inflation in the panel fixed effect least squares regression. On the contrary, institutional quality has no statistically significant effect on output volatility in the instrumental variable regression for the full set of countries. However, there seems to be a more significant negative effect of institutional quality on output volatility in the panel least squares as well as the TSLS estimation of Latin American countries as compared to the full sample.