Inequality and the Instability of Polity and Policy

In this paper, we create alternative measures of political instability, which capture movements only from dictatorship to democracy and vice versa (consistent with the recent theoretical work by Acemoglu and Robinson) but, unlike older, well known measures do not capture government changes that preserve the democratic or dictatorial structure of the country. Our empirical work clearly shows that inequality is positively correlated with our measures of political instability as well as with a well-known measure (used by Alesina and Perotti), but the impact of inequality on the latter is only through components of political instability as captured in our measures. We also find that our measure of political instability has significant policy implications - it increases the volatility of both trade and fiscal policies. Furthermore, policy volatility exercises a debilitating influence by intensifying the volatility of output. Output volatility is affected by political instability but only through its effect on policy volatility. We find strong evidence of a channel that starts from inequality, which then affects political instability (as measured by us), which in turn affects policy volatility and then output volatility. Finally, we examine and find that the instability of policy and polity has adverse effects on both investment and economic growth