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Cheng-Te Lee, Department of International Trade, Chinese Culture University, No. 55, Hwa-Kang Road, Yang-Ming-Shan, Taipei City 11114, Taiwan. Tel: 886-2-2861-0511 ext. 35135; Fax: 886-2-2861-8290; Email: The paper has benefited from valuable suggestions given by Professor Lai, Ching-Chong, Shieh, Jhy-Yuan and participants in the 2005 Conference on Taiwan Economic Association. We are grateful to the editors and the anonymous referees for useful comments on the earlier version of this paper. Lin also gratefully acknowledges the financial support from the National Science Council, Taiwan (NSC 94-2415-H-004-002). Any remaining errors are our responsibility.


This paper analyses the impact of home military spending and foreign military threat on economic growth in a stochastic endogenous growth model involving the supply-side and demand-side effects produced by military spending. The paper states that an increase in home military spending affects economic growth through three channels, including the crowding-out effect, the spin-off effect, and the resource mobilization effect. The net effect which depends on these three channels is ambiguous. Hence, we demonstrate that there exists an optimal defence burden that maximizes the economic growth rate. Furthermore, the optimal defence burden depends on the degree of risk preference. Namely, the optimal defence burden of the risk-loving agent is more than that of the risk-neutral agent, and in turn is more than that of the risk-averse agent. At the same time, we prove that the relationship between the volatility in military spending and economic growth also depends on the degree of risk preference. In addition, we show that greater volatility in foreign military spending leads to a decrease in home aggregate consumption, and hence speeds up economic growth in the home country.