Non-Linear Effects of Government Size and Institutional Quality on Macroeconomic Performance in Sub-Saharan African Countries

Abstract

The size of government and the quality of institutions are crucial factors in a country's macroeconomic performance. The extant literature has provided evidence that a larger government and high-quality institutions can reduce output volatility and stabilize inflation, thereby contributing to sustainable economic growth in countries. The stable economy can then be leveraged to enhance social security for the benefit of the unemployed, children, the disabled, and the elderly, particularly in a developing sub- region like Sub-Saharan Africa (SSA). However, the impact of government size and institutions on the economies of SSA countries has been under-researched. Furthermore, the exact threshold levels of government size and institutional quality above which output volatility and inflation can be reduced or amplified, respectively, remain unknown for the SSA countries, despite their high volatility of output and inflation compared to other developing countries. Also, little is known about whether the magnitude of the impact on inflation of a decrease and an increase in government size is the same or not in the long run for the SSA countries. This thesis, therefore, attempts to fill the knowledge gaps about the experiences of the SSA countries. The first essay aimed at examining the threshold effects of government size on output volatility in Sub-Saharan African countries (SSA) and subsequently estimating the factors that determine output volatility. The study covered 22 SSA countries spanning over 1997-2021 period. Hansen’s (1999) threshold methodology was used to estimate threshold levels of government size on output volatility. The findings show that there is a threshold value of government size on output volatility in SSA countries. The study further reveals that government size below the estimated threshold has a more positive impact on output volatility than above the threshold level. The implication is that smaller government size amplifies output volatility and government size above the estimated threshold has a weakening positive impact on output volatility. This may partially support the Keynesian paradigm. The study further revealed that only financial development and inflation variables have a negative and statistically significant relationship with output volatility. Foreign direct investment, trade openness, and institutional quality index variables are weakly and positively related but have a statistically insignificant relationship with output volatility. These findings have policy implications, suggesting that policymakers should consider the estimated threshold level to mitigate output volatility. Furthermore, the development of the financial sector iii and economic diversification are crucial in mitigating the volatility of output that may result from economic globalization in SSA countries. In the second essay, we examined the effects of asymmetry and causality between government size and inflation. The conventional panel ARDL, the panel non-linear ARDL, and the Toda and Yamamoto methods were used in the estimation. The findings of both panel ARDL and panel non-linear ARDL suggest that government size and inflation have a significant long-run relationship. Thus, government size exerts a significant influence on inflation in SSA. The study further revealed that government size has an asymmetric relationship with inflation, showing that a decrease in government size has a more significant impact on inflation than its increase. The results of the causality test show a significant bi-directional causal relationship between the two variables. Among the control variables, exchange rate, food production, and interest rate seem to be inversely related to inflation in the long run. However, money supply, GDP, and institutional quality appear to have a statistically insignificant influence on inflation in the long run. Lastly, we investigated the threshold effects of institutional quality and causality on inflation. The FD GMM, dynamic panel threshold of Seo and Shin (2016), and Toda and Yamamoto (1995) methods were used in the estimation. The findings suggest that institutional quality exerts a significant impact on inflation in SSA. The results further show that institutional quality has a threshold effect on inflation. Institutional quality impacts inflation significantly, both below and above the estimated threshold. However, the magnitude of impact on inflation is economically larger above the estimated threshold than below it. The study further revealed that past period inflation, government size, GDP, exchange rate, money supply, and interest rate are inversely related to inflation and statistically significant, except for GDP, which appears to be statistically insignificant. On the other hand, the food production index has a positive effect on inflation and is statistically significant. These findings have policy implications in that the fiscal authority should embark on institutional quality reforms, and the monetary authority should focus on the conventional monetary policy instruments within the framework of the policy mix to control inflation. Policymakers should consider increasing social security spending to provide relief to the unemployed, elderly, and disabled in response to external risks iv exacerbated by globalisation. SSA governments should also prioritise investing in the development of the financial sector to foster sustainable economic growth, as financial development appears to have a more substantial impact on output volatility. Economic diversification is another key strategy to mitigate both domestic and global risks. A practical approach would involve attracting private sector investment by strengthening governance and focusing on the development of financial intermediaries, which have proven effective in allocating resources between lenders and borrowers Further, membership by the SSA countries to regional bodies such as WAEMU, CAEMC, SADC, and AMU is also encouraged since these regional bodies expect their members to maintain certain higher levels of governance for improving the performance of their economies