By making use of annual data from Malaysia for the period 1970 to 2006, this paper examines Wagner’s law and the Keynesian hypothesis concerning the link between real government spending and real GDP. Unlike most existing studies, we utilize both a bivariate and a multivariate model. In addition, we consider two cases: one that focuses on the link between aggregate government spending and GDP and the other where the link between government spending on education and GDP is considered. The use of a multivariate model serves to reduce the problem of serious misspecification which appears to have been ignored by most existing studies. The presence of cointegration is investigated by means of Auto Regressive Distributed Lag (ARDL) approach. This approach also allows one to distinguish between the short and the long-run relationships. Within the context of a bivariate model, our empirical analysis reveals that aggregate government spending Granger causes the real GDP which supports Wagner’s law. However, in a multivariate framework, we found support for the Keynesian hypothesis suggesting that omitted variables bias can significantly alter the validity of Wagner’s law.
Economic Change and Restructuring / Vol. 44, No. 3, pp.203-219