The Economic Effects of Government Behavior: A Macroeconomic Theory of Multi-Layered Governance in China

Developing a macroeconomic theory for China’s transitional economy requires a micro-foundation that accounts for both government and market. This paper proposes a macroeconomic framework featuring endogenous decision-making by multi-layered governments, with central-local strategic interactions and regional competitions. By incorporating the central government’s bottom-line constraint and local government performance evaluation, we explore the intrinsic mechanism driving the shift in top-down evaluation systems from single target to multiple targets and the regional spillover effects of endogenous target transformation. This framework captures the endogenous selection and evolution of macroeconomic policies and their transmission across different levels of government and market participants. The paper sheds light on how government behaviors shape macroeconomic dynamics. We apply the theoretical framework to analyze two cases: the transition of environmental policies in the course of economic development and the reform of local government debt. We also discuss potential extensions, including incorporating local governments’ explicit constraints, economic uncertainty, and dynamic general equilibrium settings. By adopting a micro-founded perspective on government decision-making, this study provides a rigorous theoretical framework for understanding China’s macroeconomic dynamics.