Does economic growth lead to democracy? This question is at the heart of our understanding of how politics and the economy interact. The answer also exerts huge influence on policy: if we believe economic growth leads to democracy, then we may be more willing to pursue economic growth first and let democracy come later. If economic growth does not lead to democracy, then perhaps economic sanctions or other tools may make sense if we wish to promote democracy. Acemoglu, Johnson, Robinson, and Yared (2008) analyzed this question by using data on democracy and GDP growth from 1960 to 2000 . The data is in the form of five-year panels - one observation for each country every five years. Table 9.11 describes the variables.

(a) Are countries with higher income per capita more democratic? Run a pooled regression model with democracy (democracy_fh) as the dependent variable and logged GDP per capita (log_gdp) as the independent variable. Lag log_gdp so that the model reflects that income at time \(t-1\) predicts democracy at time \(t\). Describe the results. What are the concerns with this model?

(b) Rerun the model from part (a), but now include fixed effects for year and country. Describe the model. How does including these fixed effects change the results?

(c) To better establish causality, the authors use 2SLS. One of the instruments that they use is changes in the income of trading partners (world-income). They theorize that the income of a given country's trading partners should predict its own GDP but should not directly affect the level of democracy in the country. Discuss the viability of this instrument with specific reference to the conditions that instruments need to satisfy. Provide evidence as appropriate.

(d) Run a 2SLS model that uses world-income as an instrument for logged GDP. Remember to lag both. Compare the coefficient and standard error to the OLS and panel data results.

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TABLE 9.11 Variables for Income and Democracy Data Variable name democracy_fh log_gdp worldincome ycar YearCode CountryCode Description Freedom House measure of democracy (range from 0 to 1) Log real GDP per capita Trade-weighted log GDP Year Order of years of data set (1955 = 1, 1960 = 2, 1965 = 3, etc. Numeric code for each country