Government expenditure and economic growth: A heterogeneous-agents approach

Abstract

This study examines the relationship between productive government expenditures and economic growth. An R&D-based model of endogenous growth is used, in which agents have heterogeneous entrepreneurial abilities. We show that if the number of high-ability entrepreneurs is non-negligible, then the relationship between the government expenditure/GDP ratio and the economic growth rate is depicted by an inverted U-shaped curve with a flat top. The flat top of the curve indicates that changes in the size of the government expenditures have a limited impact on growth. We calibrate the model using U.S. data and empirically confirm our theoretical predictions. The theoretical and numerical results suggest that the debate on the relationship between the size of the government and economic growth may be off the mark unless the size of the government is extremely large or small.