DP10373 Institutions, Volatility and Investment
Countries with strong executive constraints have lower growth volatility but similar average growth to those with weak constraints. This paper argues that this may explain a strong reduced-form correlation between executive constraints and inflows of foreign investment. It uses a novel dataset of Dutch sector-level investments between 1983 and 2010 to explore this issue. It formulates an economic model of investment and uses data on the mean and variance of productivity growth to explain the relationship between investment inflows and executive constraints. The model can account for the aggregate change in inflows when strong executive constraints are adopted in terms of the reduction in the volatility in productivity growth. The data and model together suggest a natural way of thinking about country-specific heterogeneity in investment inflows following the adoption of strong executive constraints.